Traders Look to Exploit ETF Weakness
Posted on September 30, 2015 by Brad Hoppmann
Aristotle first postulated the theory that "nature abhors a vacuum," meaning that empty or unfilled spaces are unnatural. As such, they go against the laws of physics.
In other words: Where there is a niche to exploit, that niche will be exploited.
This Aristotelian physics principle also applies to Wall Street traders.
Like molecules filling a void, where there is a niche profit opportunity to exploit, you can rest assured someone in a high-rise Manhattan office building will be burning lean tissue trying to figure out how best to exploit it.
The latest exploitable niche is the Exchange-Traded Fund market — a verdant pasture that many big names on Wall Street are just waiting to run carefree through in the pursuit of big profits.
One such trader poised to pounce is Steven A. Cohen of Point72 Asset Management (formerly SAC Capital).
The hedge fund manager is already shaping trades around ETFs designed to take advantage of "structural weaknesses in the industry."
ETF pie
According to a story in Wednesday’s Wall Street Journal titled, "Traders Seek Ways to Benefit From ETFs’ Woes":
Wall Street is concocting ways to capitalize on potential weak spots in Exchange-Traded Funds, which showed signs of vulnerability during the recent market turmoil.
The "recent market turmoil" referred to here is something we talked about on Aug. 25, "Avoiding the Emotional Bouncing Market Ball."
In that piece, we looked at the massive volatility that took place in markets on Monday, Aug. 24, when the Dow plunged nearly 1,100 points in the first five minutes of trade.
Here’s what we said about the significant damage that took place in ETF land that day …
(The broader market) volatility was meager compared to what happened in some ETFs.
In fact, yesterday there was a massive mispricing of many big ETFs that many now describe as a "mini flash crash."
That’s right, some ETFs saw crazy pricing during the early going yesterday, and some of the ETFs in question were very widely held.
According to ETF.com, the iShares Select Dividend (DVY) was down about 36% in the early going Monday. The Guggenheim S&P 500 Equal Weight (RSP) sank as much as 42% at one point while the iShares Conservative Allocation Fund (AOK) traded approximately 50% below its Friday close.
This damage didn’t go unnoticed by Cohen & Co., and why should it?
After all, hedge funds exist to make money for their clients. Nothing more, nothing less.
And, if there is money to be made by pricing issues or structural issues that can cause price discrepancies like the aforementioned, then it is not only OK for hedge funds to do so …
It is incumbent upon them to take the necessary profit-generating actions.
***
So, how are hedge funds like Point72 and others planning on profiting from cracks in the current ETF armor?
According to the WSJ, Mr. Cohen’s Point72 are targeting commodities ETFs such as the U.S. Oil Fund (USO), which tracks the price movements of crude.
They have identified what they say is a weakness in many funds’ operations that they can exploit in stable or volatile markets: ETFs including USO reshuffle their portfolios on the same handful of days every month.
Point72 and others have found that if they can anticipate moves they know the ETF will employ, they can profit from the products’ buying and selling activity during that same period every month.
This is a new twist on a classic Wall Street "roll trade" because the ETF is rolling over its holding of one futures contract that is close to expiring for one expiring a month later.
Other tactics by hedge fund managers aside from Cohen include shorting thinly traded ETFs. Consider that a quick exit from one or more of the components of that thinly traded ETF can cause a pronounced dive in the actual ETF. (Which, of course, is good if you happen to have a short position in that fund.)
ETF pie
Still other prominent hedge funders are shorting both bearish and bullish leveraged ETFs in the same industry:
If the market goes up, the bearish ETFs will fall more than the bullish ones gain, allowing the trader to make more on his short of the bearish fund than he lost on the short of the bullish one. The trade also pays if the market goes down.
Now, if this sounds complex to you, I totally understand. Even I had to chew on the concepts here for a bit before I could thoroughly digest them.
***
For me, there are several wider takeaways from this story.
First, no matter what kind of positives there are to an investment product (and ETFs are mostly positive), there will always be ways to exploit their structure and take advantage of their nature.
Second, if you own ETFs (and you should) you need to be aware that despite their virtues, nothing is without its flaws. The Aug. 24 mispricing "mini-flash crash" taught us that.
Third, although it may seem a little uncomfortably unctuous, the existing of hedge funds committed to exploiting deficiencies, weaknesses and vacuums in the market are actually good for investors.
Why?
Because it exposes flaws that can then be addressed with improvements in the products.
Think of it this way — you won’t know if you have a leaky roof until you get a big rain.
But after that big rain, you’ll know what part of your roof you’ll need to fix.
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Are you surprised by hedge funds pursuing flaws in ETFs for profit? Are you concerned about your ETF holdings after the Aug. 24 mispricing fiasco?
Tell me what you think by leaving a comment on our website or by sending me an e-mail.
***
U.S. stocks finished firmly in positive territory Wednesday; however, stocks suffered their worst quarterly loss in years. The S&P 500 fell about 8.3% in Q3.
• U.S. home prices rose 0.6% in July, according to the S&P/Case-Shiller 20-city composite released Tuesday. After seasonal adjustment, prices slipped 0.2%.
• Gold futures were down for a fourth-straight session. Gold prices lost 1.5% for the month, and 4.8% for the quarter. Year-to-date, gold is down 5.8%.
• Oil futures were lower Wednesday, a fitting end to the horrid quarter for crude. Oil futures were down nearly 25% over the past three months, a downtrend fueled by a massive global supply glut.
• Chesapeake Energy (CHK) gained nearly 8% in today’s session after announcing that it would cut about 740 jobs, slashing its workforce by 15%.
• At the 11th hour, Congress avoided a potential federal government shutdown. This afternoon, the House sent a spending bill to President Obama that is set to keep the U.S. government operating through Dec. 11.
Good Luck and Happy Investing,
Brad Hoppmann
Publisher
Uncommon Wisdom Daily
P.S. My approach to trading ETFs is simple: Only trade highly liquid ETFs … rotate capital out of funds that are losing strength, and into those that are gaining strength … and don’t spend any more than 10 minutes a month doing so! In fact, earlier today I sent my 10-Minute ETF Trader members my trading system’s top three picks for the month. It’s not too late to get in on them. Click here to learn more.