According to an expose by the Wall Street Journal, several well-known hedge fund managers have found ways to capitalize on structural efficiencies in exchange-traded funds to make profitable short-term trades.

Hedge funds and other traders have been designing investment schemes to take advantage of shortcomings in how ETFs are structured and operated. As the WSJ points out, in many cases these traders make handsome profits while retail investors holding low-cost ETFs in their portfolios suffer.

One example of  the kind of structural inefficiency we are talking about hit some ETFs in August of this year. When stock markets in China and around the globe collapsed, many equity ETFs traded at notable discounts to the sum of their holdings for a short time, and then stabilized within a couple of days. That said, the large imbalance was great news for hedge funds and traders who had been making wagers against ETFs that generate small profits in calm markets and bigger profits in more volatile environments.

Volatility ETFs

Hedge funds running a “sting” on ETFs

The WSJ article, written by Rob Copeland and Bradley Hope, highlights that firms such as Steven A. Cohen’s Point72 Asset Management and Ian McDonald’s Hilltop Park Associates have been scheming up trades involving ETFs, and are starting to profit off of their exploitation of structural weaknesses in the industry.

The basic premise behind the ETF trades is that the price swings in the funds are occasionally are bigger than the moves in their underlying assets. For example, August 24th when the market was swinging wildly,  BlackRock’s iShares Select Dividend ETF was briefly off a shocking 35%. although none of its holdings were ever down that much.

Ian McDonald is the managing director at Hilltop Park, and he has establishing short positions against the individual holdings of ETFs such as PureFunds ISE Cyber Security ETF. His logic is that money has flowed into the ETF at high speed recently, pumping up shares of these companies relative to their peers that are not part of the fund’s holdings.

Therefore, when investors start pulling money out of the fund and the funds are forced to quickly sell their holdings, these stocks will fall more than their sector peers. McDonald decided to focus on this fund because cybersecurity is a relatively unknown industry with thinly traded stocks, so the ETF’s selling should increase the price declines of those stocks.

Is hedge fund exploitation of ETFs “morally bankrupt” or just “doing business”?

To be clear, nothing that these hedge funds are other traders are doing in creating trades around ETFs is illegal per se. There are no laws against exploiting structural inefficiencies in ETFs or other funds. That said, what benefit does society…or anybody except the trader who profits from the transaction for that matter…get from such a transaction? The answer is nothing, and some financial experts argue there is even indirect harm to ETF investors.

Unlike a “short” investor (who profits when a company’s stock goes down), who can at least claim s/he is providing investors/markets with both liquidity and a needed service in the sense of a counterbalance to overly bullish “long” investors, morally bankrupt hedge fund scum like Stevie Cohen and Ian MacDonald are just looking to make easy money.

The fact that nobody involved is actually doing anything productive such as developing a new invention or software or even making a product, means these “investors” are much more like economic leeches sucking on the body politic than anything else, especially given these blindered, rich do-nothings are indirectly hurting all the rest of us.