Of ETFs and Stripping

There's a headline that will get your attention and trust us, finding a suitable picture to go along with this story wasn't the easiest of tasks. Such is life when writing about stripping. No, not the nefarious kind that involves shady clubs, $1 bills and lasses that are allegedly putting themselves through law school without being able to tell Judge Judy from Sandra Day O'Connor. Nope, we're talking about ETF stripping. Reportedly it's all the rage among insider traders and the SEC is taking issue with it, having launched an investigation into this tawdry deed. Here's how it works: A tipster gives the trader info about ABC Inc. The trader then proceeds to buy an ETF that includes ABC among its holdings while shorting the ETF's other constituents. In theory, this would allow the trader to benefit from price action in ABC without actually owning the shares, in effect masking a trade in that stock. Regulators, who work closely with the Justice Department, are worried that ETF stripping is proliferating in an effort to veil insider trading, the Financial Times reported. Obviously, this will bring out the ETF haters again for some more pointless opining about the dangers of ETFs to keep retail investors stuck in the mutual fund rut. That's a given, but will be really interesting will be the discovery of whether or not ETF stripping actually works. It could work, but the number of ETFs that could be used for the practice appears limited. Here's a hypothetical example: Assume a trader wants to be long Intel

via an ETF while shorting other semiconductor makers. A good idea might be buying the Semiconductor HOLDRs

where Intel accounts for more than 20% of the fund's weight. Then the trader could pass on shorting Texas Instruments

, which accounts for 22.5% of SMH, but then short Applied Material

, Xilinx

, Broadcom

, etc. without really upsetting the long position in SMH. Even that seems dicey and ETF stripping almost certainly would be hard to execute for profit with an equal weight ETF. It seems like simple math. If a trader is long a stock through an ETF, even if that stock accounts for a disproportionate share of that ETF's weight, what happens when his shorts on 50%, 60%, 80% of the rest of the fund's holdings start working? That's almost certain to drag the ETF down, at least one would think that's what happens. Seems like there might be another term for ETF stripping: Hedging.