Front Runners

Seeking Alpha featured an interesting piece called “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.

This is one of the reasons why I never place sell stops ahead of time as “stop orders.” I don’t want to get stopped out because of alleged front running activities or simply other intraday market noise.

I suggest you do the same by using “day-ending closing prices” only to see if any sell stop has been triggered. If it has, only then do I enter my order the next day.

This avoids intra-day whip-saw signals and simplifies my tracking. In other words, I treat ETFs like mutual funds in that, for sell stop purposes, only one price per day exists.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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