How Traders Are Front-Running ETFs

Another aspect of exchange-traded funds (ETFs) coming to the fore lately is front-running. That’s the practice where traders buy ahead of large orders from ETFs and short sell ahead of large sell orders. They scalp profits by flipping their newly acquired long positions back to the ETF at higher prices and closing their short position at lower prices. The ETF ends up paying more to buy securities and receiving less to sell; in effect, traders have transferred profits from the ETF to themselves.

The practice has been a fixture of ETFs since they were first invented. Any time an index maker announces a change to the underlying index it is an all-points bulletin that the ETF fund will be entering the market to buy the added securities and sell the deleted ones. In the case of broad-based ETFs, the extent of the profit transfer likely isn’t too significant because the index changes usually affect just a small portion of the basket.

But the story changes as one departs from plain vanilla, broad-based ETFs. Of note, the more markets are sliced and diced into smaller slivers for ETFs to track, the more likely index changes will become significant in relation to the index basket. And, in turn, so does the opportunity for front-runners to transfer returns from ETF holders to themselves.

But perhaps the area most at risk is ETFs that use derivatives such as futures, swaps, etc to track their indexes. They track spot prices by buying the derivatives nearest to maturity, and as the derivative near expiry, roll the position into the next nearest maturity.

Knowing commodity ETFs must roll, traders have been front running it. Some serious profits have been taken away from ETF holders (see case of U.S. Oil ETF below). This is one reason ETFs aren’t tracking their commodities well; spot prices may rise but ETF holders don’t follow to the same extent; vice versa, spot prices may fall, but the ETF holders take a bigger hit.

• U.S. Oil ETF (USO) loses about $120 million (U.S.) in early 2009 when it rolls 80,000 contracts from March to April maturities

• Tussles with front-runners causing abnormal price fluctuations in natural gas futures markets and U.S. Natural Gas ETF (UNG)

• News of ETFs to be launched for a commodity can cause a run up in price, requiring the ETF to set up its basket at higher prices.

Comments

[jan v:]

I wonder if, in the case of UNG, the fact that they now use gas swaps, is changing your estimation that UNG is not efficient any more.

Oct 11 08:06 AM

[apppro:]

OK, so how do we stop that????????????? Short-term traders are screwing all the long-term investors once again, SO HOW DO WE STOP IT!!!!!!!!!!!!!!

I say tax them:


Revised Tax Rules:
1. Capital gains under <6 months - 55% tax on capital gains
2. Capital gains 6 > 12 months - 45% tax on capital gains
3. Capital gains 1 > 2 years - 35% tax on capital gains
4. Capital gains 2 > 5 years - 18% tax on capital gains
5. Capital gains 5+ years - 5% tax on capital gains
6. Most critical of all — Institute a capital gains tax of 55% on ALL short sales not directly tied to a long buy by a licensed hedge fund. I'm tired of paying for the pure shorts 3rd vacation home.

Oct 11 08:34 AM

[Baboon:]

Wow - 45% on 6-12 months gains? By no means holding stock for 6-12 month is a short-term investment.


On Oct 11 08:34 AM apppro wrote:

> OK, so how do we stop that????????????? Short-term traders are screwing
> all the long-term investors once again, SO HOW DO WE STOP IT!!!!!!!!!!!!!!
>
>
> I say tax them:
>
>
> Revised Tax Rules:
> 1. Capital gains under <6 months - 55% tax on capital gains
> 2. Capital gains 6 > 12 months - 45% tax on capital gains
> 3. Capital gains 1 > 2 years - 35% tax on capital gains
> 4. Capital gains 2 > 5 years - 18% tax on capital gains
> 5. Capital gains 5+ years - 5% tax on capital gains
> 6. Most critical of all — Institute a capital gains tax of 55% on
> ALL short sales not directly tied to a long buy by a licensed hedge
> fund. I'm tired of paying for the pure shorts 3rd vacation home.

Oct 11 09:11 AM

[searcher:]

Whoa there! 'Front Running' is called anticipation in some circles. That is the nature of any transaction not involving immediate consumption. Similar tax structures institutionalize bubbles by postponing the 'reality checks' provided by pricing mechanisms.

Oct 11 11:57 AM

[Jeff Diercks:]

This front running strategy is used successfully by several hedge funds as the sole method by which they generate alpha. Of course, they just don't front run the ETFs, but also any managed account or mutual fund that tracks an index that is adding or deleting securities from its holdings.

Oct 11 10:00 PM

[Jeff332:]

Dude,
It's not the short term traders that you should worry about. It's the prop desks & program trading computers at GS and others that skim all the cream off the market. They own us.

The small short-term trader is at their mercy just like the long term investors. Simply put, far too much of the market is traded by GS, etc. They know they can influence prices and they do it. Putting a tax on short term gains would only hurt the short term trader. GS et all would figure out a way around it (or lobby a way around it). What should have happened is Obama should have let them go out of business and not bailed anyone out. Changing the rules mid-game hurts everyone.


On Oct 11 08:34 AM apppro wrote:

> OK, so how do we stop that????????????? Short-term traders are screwing
> all the long-term investors once again, SO HOW DO WE STOP IT!!!!!!!!!!!!!!
>
>
> I say tax them:
>
>
> Revised Tax Rules:
> 1. Capital gains under <6 months - 55% tax on capital gains
> 2. Capital gains 6 > 12 months - 45% tax on capital gains
> 3. Capital gains 1 > 2 years - 35% tax on capital gains
> 4. Capital gains 2 > 5 years - 18% tax on capital gains
> 5. Capital gains 5+ years - 5% tax on capital gains
> 6. Most critical of all — Institute a capital gains tax of 55% on
> ALL short sales not directly tied to a long buy by a licensed hedge
> fund. I'm tired of paying for the pure shorts 3rd vacation home.

Oct 12 04:38 PM

[H. T. Love:]

I find a case for shifting more $ to the government an undesirable solution.

Another way to generate the financial incentives to produce the results you target are needed.

To again turn to government as a solution to perceived "unfair" woes generated by a "free market" (no discussion of this needed here) falls right in line with structural changes that have damaged this country (irrepairably?) over decades.

I've not given this much thought, but it seems to me that a better solution is to partly "make whole" those damaged by what you find to be objectionable activities.

If you believe you have a rational case that investors who have been damaged by objectionable activities are a "more deserving class" than "traders" or "speculators" (let's not get side-tracked by the true meaning of that word), why shouldn't any confiscations (note: I do *not* use the word "tax" for good reason) be used to "make whole", to some formulaic degree, those who were harmed.

I suggest that by proposing a tax that goes to government coffers you are being rather myopic because you ignore the long-term harm done to *all* participants by further empowering an already-known destructive force in our society - the government(s).

A better strategic view, it seems to me, always includes a way to keep more of the capital in private hands.

I do not endorse your basic premises, but that is irrelevant to my thoughts about your proposals. I do support "proper regulation and enforcement" of rules and agencies that level the playing field and/or support strategic goals, such as long-term investment. That does not mean that "trading" should be considered "bad" just on the face of it.

HardToLove

On Oct 11 08:34 AM apppro wrote:

> OK, so how do we stop that????????????? Short-term traders are screwing
> all the long-term investors once again, SO HOW DO WE STOP IT!!!!!!!!!!!!!!
>
>
> I say tax them:
>
>
> Revised Tax Rules:
> 1. Capital gains under <6 months - 55% tax on capital gains
> 2. Capital gains 6 > 12 months - 45% tax on capital gains
> 3. Capital gains 1 > 2 years - 35% tax on capital gains
> 4. Capital gains 2 > 5 years - 18% tax on capital gains
> 5. Capital gains 5+ years - 5% tax on capital gains
> 6. Most critical of all — Institute a capital gains tax of 55% on
> ALL short sales not directly tied to a long buy by a licensed hedge
> fund. I'm tired of paying for the pure shorts 3rd vacation home.

Oct 12 05:06 PM