The SEC’s administrative action against Spencer Mindlin & Dad yesterday had me scratching my head, and not just because TD Ameritrade managed to record a conversation between Mindlins père and fils when they had Ameritrade on hold. That should not be possible.

From what I’ve seen of this case it really doesn’t look like insider trading to me, though I’m always less willing to see insider trading than, say, the SEC is. But more interesting to me is what the case shows about the ETF market.

Here’s the gist of the SEC’s complaint. Goldman was long a lot of shares of XRT, an ETF on an equal-weighted index of retail stocks. Goldman hedged by selling shares of the underlying index components. (Delta one, remember?) The index rebalanced quarterly, including sometimes adding and deleting stocks. When that happened, Goldman would adjust its hedge, shorting the added stocks and buying in the dropped ones. For instance, on December 21, 2007, the index added shares of Sport Supply, a small-cap illiquid company. Goldman sold shares of Sport Supply on the rebalance date. So did other banks with similar positions, though Goldman’s may have been the biggest. The result was that Sport Supply got crushed, dropping from $9.18 to $7.00 that day.

If you knew that chain of events in advance you could do things like short Sport Supply, or buy puts on it, in advance of Goldman’s trading, and profit from the decline. Mindlin apparently did, and he did. So, fine.

Here’s what his lawyer has to say about it:

“This is a situation where a son working in the securities industry suggested a trading strategy to his father and helped the father understand and execute the strategy,” said the attorney, Robert Knuts of Park & Jensen LLP. “That strategy was not based on any confidential information obtained by the son.”

Mr. Knuts added that the strategy was based on a well-known rebalancing tactic within the ETF industry and on publicly available information.

Now, that seems obviously right to me. Mindlin junior did apparently say vaguely sneaky-sounding things to his dad, but that doesn’t make him an insider trader. The rebalancing of the index, and of XRT, were publicly announced, in advance. Mindlin had no inside information about those things. He knew that banks would adjust their hedges, but the mechanic of hedge adjustment is obvious – you just equal-weight the shares in the index. The only nonpublic information that the SEC claims the Mindlins had was Goldman’s position. But as the SEC says, other dealers adjusted in the same way. It doesn’t matter what Goldman’s position was. All that matters is that a lot of dealers would be hedging by selling Sport Supply on the rebalancing date.

Okay. But the surprise to me is that the SEC complaint – and the lawyer’s response – leaves out the other side of the market. Here’s my naïve understanding of how an ETF works: State Street sells a share of XRT to you. That share of XRT represents a claim on 1 share of Stock A, 1 share of Stock B, 1 share of Stock C, etc. [I am stylizing this as equal-number-of-shares-weighting; it's actually equal-dollars weighting so it's really $1 worth of Stock A, etc., but who cares.] State Street takes your money and goes and buys 1 share of Stock A, 1 share of Stock B, 1 share of Stock C, etc.

So now imagine the following setup:
1. State Street sells 17 million shares of XRT, buys 17mm shares of Stock A, 17mm shares of Stock B, … 17 million shares of Sport Supply
2. Goldman buys 4.35mm shares of XRT, JPMorgan buys 3mm shares, ….
3. In total banks own, pick a number, 10 million shares of XRT
4. They hedge that exposure by selling 10 million shares of Stock A … 10 million shares of Sport Supply.

Right?

So if the ETF works like that, on the rebalancing date, banks sell 10 million shares of Sport Supply, and State Street buys 17 million shares of Sport Supply. So Sport Supply goes … up?

Now this is obviously – from the world-class, down-22%, worse-than-MS-today accident that happened to Sport Supply on the rebalancing date when Spencer Mindlin and Dad made their sweet, sweet … $24,608 in profit – not what happened. What happened instead is – has to be – State Street buys 17 million shares of Sport Supply, and banks sell … 50 million shares or something. Because the banks are long 50 million shares of XRT.**

Meaning that the banks are long a very large multiple of the number of shares of XRT that exist.

You can’t really do that with stock, normally, but you can with ETFs. Coincidentally FT Alphaville ran something about this very ETF just about a year ago:

Take the SPDR S&P Retail ETF (NYSE: XRT) as an example. The number of shares short was nearly 95 million at the end of June, while the shares outstanding of the ETF were just 17 million. The ETF was over 500% net short! Or to look at it from another perspective, the ETF’s operator, State Street Global Advisors, believed that there were 17 million shares of the SPDR S&P Retail ETF in existence and owned shares in the S&P Retail Index portfolio to underlie those 17 million ETF shares. But, in the marketplace there were another 95 million shares of the ETF owned by investors who had purchased them (unknowingly) from short sellers. 78 million of those ETF shares were naked short–the short seller had promised their prime broker to create those non-existent shares if necessary to cover their short in the future. In both cases the share buyer, however, is completely unaware his ETF shares were purchased from a short-seller and no doubt assumes the underlying assets in the index are being held by the ETF operator on his behalf, but no such underlying stock is actually held by anyone. Clearly this creates a serious counterparty risk and quite possibly the potential for a run on an ETF—where the assets held by the fund operator could become insufficient to meet redemptions.

Sort of true – but the Mindlin case if anything suggests we should be less worried. It shows that hedged long ETF investors (i.e. dealers) are much bigger, at least in XRT, than hedged short ETF investors (like, for instance, the ETF itself). It also suggests that concerns that the “share buyer is completely unaware his ETF shares were purchased from short sellers” are overblown. The buyers of ETF shares, at least in XRT, are dealers – they know that they’re facilitating shorting, they’re unlikely to run on the ETF, and they’re hedging the risk in the underlying stock.

** From State Street’s filings, it seems like XRT bought about 280k shares of Sport Supply in December 2007. The SEC complaint claims that Goldman had to sell 225k shares of Sport Supply to adjust its hedge. So XRT’s position in Sport Supply is slightly bigger than Goldman’s short – but not much bigger, and apparently meaningfully smaller than the combined short of all the dealers who own XRT.