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Over the past couple years, borrowing and shorting activity in ordinary equities has not rebounded as much as borrowing and shorting activity in ETFs, as shown by the chart below. Also, investors are rushing into long positions of ETFs even as they withdraw money from US mutual funds.
Why are hedge funds shorting ETFs? Or first, which ETFs are the most popular short plays?
The most popular ETF short right now is UWM, the levered ProShares Ultra Russell2000. Following UWM, the other ETFs that are high in demand to short at DUG, DOG, and TNA.
It’s been widely discussed how the levered ETFs do not properly track their underlying indexes over a longer time period. However, where there is an inefficiency, there is an opportunity to exploit it.
Since levered ETFs tracking performance will break down over time as the underlying index fluctuates, one possible trade would be for hedge funds to short the levered ETFs and go long the underlying index. As the index fluctuates over time, for instance declining 10% and then rising 11.1% to get back to the same position, the index will be even but the levered ETF will be underwater. Then the hedge fund can close out the short position in the levered ETF for a profit and sell his long position in the index for no profit/loss.