Exploiting ETF Structural Flaws Is Not as Easy as It Looks

Potentially profitable but also uncommon.

Trading ETFs maybe.

Photographer: Michael Nagle/Bloomberg

Hedge funds may need to get back to the drawing board if they're planning to turn around their performance struggles by capitalizing on “shortcomings in the ETFs’ structure” via some unusual trade ideas, as highlighted in this recent Wall Street Journal article. Most funds do nothing of the sort.

The vast majority of ETF usage by hedge funds is very boring. They love to short ETFs to get their hedge on and isolate some kind of risk. For example, they may short the Health Care Select Sector SPDR ETF (XLV) and then make a bet on one of the health-care stocks in the basket in order to quarantine a single security bet. Hedge funds have about $116 billion worth of ETF shares shorted, compared with only $34 billion in long positions, according to data compiled by Goldman Sachs last year.

The $34 billion in long positions is them using ETFs like everyone else — as a way to get quick and convenient exposure to a particular market. For example, the world’s largest hedge fund, Bridgewater Associates, has a $4 billion position in the Vanguard FTSE Emerging Markets ETF (VWO), which it has held for six years now.  There's also Paulson & Co.'s famous $1 billion position in SPDR Gold Trust (GLD), which it has been holding for almost seven years. Like anyone else, they like the cheap exposure and liquidity VWO and GLD serve up.

With that context in place, yes, there are a tiny minority of hedge funds that engage in some complex trades like the ones highlighted in the article. But each trade comes with at least one big problem.

Before anyone tries any of these at home, it's important to deconstruct them.

Trade #1: Robbing Grandma

How it works: During a major selloff, try and scoop up shares at discounted prices put in by small investors using market orders.

The problem: It’s super rare. Aug. 24, which saw hundreds of ETFs trade at sharp discounts amid a major selloff, was basically an anomaly. At best, a day like that happens once every two years. Thus, to capitalize on discounts of the 20-30 percent variety is like standing on a beach waiting for a hurricane to hit. And you won’t be the only one, so you may wait two years only to find you can’t get your order filled on the day the big one hits. In addition, no large institutional investors are putting in market orders. So this low-hanging fruit is sell orders for tiny amounts put in by unknowing small investors. Essentially this is the white-collar equivalent of robbing Grandma for some loose change in her purse.

Moreover, Aug. 24 may never happen again, at least the way it unfolded. ETF issuers are working with the exchanges, the regulators, and the market makers — and even making significant recommendations — to make sure those kinds of small investors aren’t exposed again like that.

It should be noted, though, that arbitrage between the ETF price and the value of the holdings happens day in and day out with ETFs — that's how ETFs work. They rely on a network of market makers and authorized participants to arbitrage away the discrepancy between the ETF's underlyings and its net asset value (NAV).

Trade #2: The Double Short

How it works: Basically you short both the long and short versions of a leveraged ETF to profit from the decay that forms from the daily resetting of the leverage amount.

The problem: The tail risk. While the trade works about 70 percent of the time, according to a study by Credit Suisse, when it doesn’t work, the negative returns can be big — very big. This trade gets blown up when there's no volatility but rather consecutive days of one-direction movement and compounding returns. Also, there's a cost to borrow the shares. The expected decay from volatility has to be greater than the cost of borrowing and you have to have the stomach for potentially big losses.

Despite all that, this is probably the most legitimate hedge fund-style trade happening that feeds off of a structural issue. About 10 percent of all the volume in three-times leveraged ETFs is this trade, according to research from Direxion. 

Trade #3: Front-Running Futures

How it works: Make money by trading futures around the time that an ETF is "rolling" its position from one month to the next.

The problem: The ETF roll may not affect the market all that much. Commodities ETFs don’t own that much of the futures market. For example, even the largest futures-based commodity ETF, the $2.5 billion United States Oil Fund LP (USO), only owns around 4 percent of all West Texas Intermediate futures contracts and about 6 percent of the first three months. That leaves a lot of other forces at work besides the USO’s buying and selling — not to mention they break up the roll into a few separate chunks to help avoid this. And that's the largest ETF. The rest are even smaller players in their respective markets.

This is the problem with trying to front-run ETFs’ rebalances in general — they simply do not own that much to make a major impact. At $2.1 trillion in assets, they own no more than 4 percent of all the markets they track, be it equities, fixed income, physical commodities, or futures markets. In short, ETFs trade a ton, but they own an ounce.

As shown, all three of the above trades are fascinating ideas, but far from easy money. That's why the vast majority of hedge funds don’t do this kind of thing. The truth is they mostly use ETFs like any other institutional investor — as just another portfolio management tool. 

Eric Balchunas is an exchange-traded-fund analyst at Bloomberg. This piece was edited by Bloomberg News.

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