Shorts In A Pickle With A Hot ETF's Holdings

The financial services sector has been scorching hot over the past two months, and with the sector's earnings season in full bloom, some short sellers are taking the opportunity to prepare for pullbacks.

Exposed: Between Bases

That includes rising short interest in smaller, community banks that have been particularly hot since Election Day. These banks are considered rate-sensitive and have subsequently benefited from the Federal Reserve's lone interest rate hike of 2016 last month. Additionally, speculation that the Fed is on course to raise rates several times this year has lifted exchange-traded funds such as the First Trust NASDAQ ABA Comm Bnk Indx Fnd QABA.

Root For The Home Team

Underscoring it sensitivity to rising Treasury yields, QABA is up 50.4 percent over the past year compared to a gain of almost 35 percent for the Financial Select Sector SPDR Fund XLF, the largest financial services ETF, over the same period.

However, QABA's recent bullishness and that of many of its 160 components could be encouraging short sellers to target smaller community banks. On the other hand, the rally in these stocks is also forcing rampant short covering.

“Banks, especially smaller regional institutions, have disproportionally felt this rally and we’ve witnessed large portions of short covering among many of the eight heavily shorted banks announcing earnings this week, all of whom are on the smaller end of the banking sector,” according to a recent note by Markit.

The Lineup

QABA tracks the NASDAQ OMX ABA Community Bank Index. In addition to meeting operating history and solvency requirements, member firms of QABA's index “must have a market capitalization of at least $200 million and a three-month average daily dollar trading volume of at least $500 thousand,” according to First Trust.

Community banks are seen as prime beneficiaries of higher interest rates. Simply put, net interest margins at regional banks have been suppressed by the Fed's zero interest rate policy and reversing that policy is seen as an important catalyst in boosting profits for the banks in ETFs such as QABA.

Of the 16 most shorted North American stocks with earnings dates this week, eight are smaller banks and four are QABA constituents. Each of those names delivers earnings on Thursday.

Last year, investors added $113.6 million in new capital to QABA, representing a significant portion of the ETF's $415.3 million in assets under management.

Disclosure: Todd Shriber owns shares of XLF.