Where Insider Trading & ETFs Meet

by on February 21, 2011 | ETFs Mentioned:

As the growth of the ETF industry has accelerated in recent years, the chorus of praises for the exchange-traded structure has become deafening in some corners of the investing world. Credited with reducing expenses, improving tax efficiency, and offering increased transparency, ETFs have received an overwhelmingly positive reception from investors both big and small.

There have, of course, been some detractors along the way, and some of the ETF critics have attracted a fair amount of attention for allegations that are often more outrageous than factual. BusinessWeek issued a blanked warning against the use of commodity ETFs last year, mistaking the nuances of a futures-based strategy for a flaw in the ETF structure (the advice is even more laughable in hindsight considering the incredible performance figures turned in by almost all commodity ETPs in 2010). A report from a Boston firm claiming that countless ETFs were in danger of “collapsing” briefly sent investors into a frenzy (an assist for the spike in anxiety goes to CNBC, which picked up the Bogan report almost immediately). And then there was the Kauffman report, which cast a slew of allegations so outrageous and wide-ranging that one industry executive quipped that “ETFs were lucky not to be associated with global warming and the BP oil spill.”

The latest blemish on the face of the ETF industry relates not to perceived structural shortcomings but to the alleged abuse of ETFs by those seeking to profit from insider information. The ETF boom has put powerful new tools into the hands of those interested in constructing a long-term, cost efficient portfolio. But it has also added to the arsenal of those engaged in illegal securities activities, including insider trading. According to the Financial Times, the Securities and Exchange Commission is taking a look at how “ETFs have emerged as a possible mechanism for maximizing gains in one stock while potentially masking trading patterns.”

A technique known as “stripping” involves purchasing an ETF that includes an allocation to a stock about which a trader has insider information, and then selling short all the other components of that fund. For example, suppose that Joe Insider knows that Exxon Mobil is going to report earnings that top Street estimates. He could buy SPY, which allocates part of its holdings to XOM, and sell short the other 500 holdings of the fund. That essentially isolates exposure to Exxon–all other positions are hedged–and could allow Joe to fly under the radar of regulators since he never purchased Exxon stock [see Five Ultra-Concentrated ETFs].

In reality, broad-based funds like SPY probably don’t make much sense for use in stripping schemes. The S&P 500 SPDR’s exposure to XOM, it’s largest individual component, is just under 3.5%. Given the diversification inherent in exchange-traded products, utilizing these products in insider trading might seem like a lot of work for very little reward. But not all ETFs are so well diversified, creating concentration risk for investors but opportunities for those looking to make an illegal buck. The Vanguard Energy ETF (VDE), for example, allocates about 22% of its holdings to XOM while the PowerShares QQQ maintains a 21% weighting to AAPL [see The Quicks Of QQQQ].

It isn’t actually that uncommon for ETFs, especially sector-specific or country-specific funds, to make allocations pushing 25% to a single company. While that obviously strengthens the dependence on that product on company-specific developments, the SEC is apparently now worried that it also allows those with insider information and the sophistication to pull off a few short sales capable of escaping detection [use the free ETF Stock Exposure Tool to see which funds have the largest allocations to any one stock].

The SEC is in the midst of a push to crack down insider trading, and that effort now includes a much closer look at the potential abuses of ETFs. It is perhaps inevitable that any advancement–whether technological or financial in nature–facilitates noble as well as malicious causes. ETFs are no different it seems, but any strippers out there are now on notice.

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Disclosure: No positions at time of writing.