WSB Finimized: Can You Profit From “Front-Running” ETFs?

WSB Finimized: Can You Profit From “Front-Running” ETFs?
Stéphane Renevier, CFA

about 3 years ago4 mins

Mentioned in story

This article is the fourth in a series examining trade ideas posted on the WallStreetBets Reddit forum.

What’s going on?

After another day scouting the dark corners of WallStreetBets to find interesting investment ideas, a post by user blk swn caught my eye. This so-called DD – WallStreetBets slang for “due diligence” – pitches buying options on two stocks, Pure Storage and Nano Dimension, that might be added to new exchange traded funds (ETFs). Addition to an ETF should, in theory, lead to buying pressure that pushes the share price higher and also moves the options. 

Why could it happen?

One of the first things I’d recommend all Finimizers to do when analyzing a strategy is to understand the underlying assumptions. In this case, success relies on four assumptions:

  • You can anticipate which stocks will be added to which ETF.
  • Buying pressures will make a significant impact on the price.
  • You can control for other factors impacting the price.
  • You know when to sell.

Let’s look at each and see which ones are likely to succeed and which ones are less likely. 

Anticipating which stock will be added to which ETF isn’t easy – but it is just about possible. In the post, blk swn  explains that all you have to do is “understand the metrics used to find new additions to these portfolio strategies”. While he didn’t share what metrics he used, he claims to have identified “two sub-$30 stocks in ARK fund ETF portfolios that are being added to BlackRock, Vanguard, Fidelity, and JPMorgan’s upcoming innovation funds.” Is the author onto something? Following the huge success of ARK Invest’s ETFs, which focus on disruptive innovation, top players like BlackRock have been launching similar ETFs, such as the BlackRock Future Tech ETF. While more research needs to be done to pinpoint which exact funds could be adding those stocks, I think it’s likely at least some of them will. 

The next assumption is that the buying flows will be large enough to move the stock price. Here blk swn smartly focuses on stocks that have a relatively small market value and low trading volume – and where passive investors could represent a high percentage of ownership in the future. Those factors could amplify the impact of flows on prices and help push them higher.

Where could it go wrong?

The thesis relies on anticipating which ETFs will include the stock. Once the news becomes public, the price will jump to reflect the index addition, significantly reducing the potential profit. It wasn’t clear from the post whether blk swn had identified potential future ETF additions or ones that have already been announced. That difference is subtle but essential. 

While I agree that flows should impact the price, I doubt flows alone could lead to “massive gains” as blk swn expects. In fact, the gains from most such “index arbitrage” strategies are measured in tiny fractions of a percentage point – so require significant leverage to be profitable. 

That brings us the next drawback of the proposed strategy: the author doesn’t suggest any ways to limit the share-price impact of other external factors. The two stocks mentioned have a lot of company-specific risks – for example if Pure Storage’s servers got hacked – in addition to the risk that the overall market tanks before the stock is added. A serious quantitative strategy would minimize these risks to isolate the price action created by the index addition. For example, you could buy Pure Storage shares while shorting (betting against) the wider cloud-storage sector, to minimize the market risk. 

These issues are compounded by blk swn’s suggestion to use relatively complex option structures to place this bet – as the price of options are influenced by many other factors, such as overall market volatility.  

Lastly, the strategy is lacking a key component: a suggestion of when should you exit the trade. Good potential exits could be either when the ETF addition is made public or when it is actually executed. 

I think the idea of anticipating ETF flows to make money is interesting and has a lot of potential. But successful implementation will require a more systematic process to screen for likely targets, smarter implementation, and better risk management.  

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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