Exchange traded funds experienced some wild swings during the recent bout of extreme volatility in the so-called mini flash crash. Nevertheless, some investors are trying to capitalize on potential ETF market inefficiencies.
Some hedge fund are crafting bets to take advantage of perceived shortcomings in the ETF structure, potentially capitalizing off arbitrage opportunities at the expense of ETF investors, the Wall Street Journal reports.
At the end of August, some stock ETFs traded at sharp discounts to their net asset value momentarily before stabilizing. Some traders see the disparity between an ETF’s price and that of its NAV as an opportunity to turn a profit.
“It’s almost like ‘I told you so,’” hedge-fund manager Ian McDonald, who is employing a series of trades to profit off weakness in ETFs, told the WSJ. “This is what I’ve been waiting for.”
Firms like Steven A Cohen’s Point72 Asset Management and McDonald’s Hilltop Park Associates are trying to profit off what they see as structural weaknesses in the ETF industry while the average retail investor suffers.
For instance, McDonald has placed short bets on the holdings of ETFs, like PureFunds ISE Cyber Security ETF (NYSEArca: HACK), an quickly growing ETF that tracks the cybersecurity sector. McDonald argues that as money funnels into the ETF, shares of the underlying securities have been elevated relative to other cybersecurity stocks that are not in the fund. Consequently, if an ETF experiences rapid redemptions, a fund company has to sell underlying components, which could cause the ETF component stocks to fall faster relative to their peers. Moreover, McDonald has targeted the cybersecurity space because it is a relatively obscure industry with thinly traded stocks, which could add to volatility.
PureFunds Chief Executive Andrew Chanin, though, reassures investors that the firm is closely monitoring the fund and holdings, and that the ETF creation/redemption mechanism is “not something they see a significant issue with at the moment.”
On the other hand, Cohen is looking into potential inefficiencies in the United States Oil Fund (NYSEArca: USO), which tracks West Texas Intermediate oil futures, during both stable or volatile market conditions. Specifically, some ETFs, like USO, rebalance holdings around specific dates, which may entice front running. In the case of USO, the ETF rolls front-month WTI crude oil contracts that are close to expiring for the next month’s contract.
Nevertheless, a USO representative told the WSJ that the practice “does not seem to be having an impact on the market or USO’s ability to achieve its objective.”
Additionally, some hedge funds have short positions in both bearish and bullish leveraged ETFs in the same industry, betting on the belief that over the long-term, high fees and a daily rebalancing will diminish the potential upside of leveraged ETFs in market upswings and exaggerate falls.
For more information on the ETF industry, visit our current affairs category.
Max Chen contributed to this article.