How Traders Are Front-Running ETFs

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Includes: UNG, USO
by: Larry MacDonald

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 (NYSEARCA: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 (NYSEARCA: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.