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What happens when a product gets too big for the index it is replicating?

There are some incredibly niche exchange-traded funds (ETFs) available to investors. For example there is an ETF that tracks drone manufacturers. The US-listed PureFunds Drone Economy Strategy ETF tracks the Reality Shares Drone Index which comprises 47 companies ‘actively involved in drone-related technologies’.

But what would happen if everyone suddenly decided drones are the future and piled en masse into the ETF? It would have capacity issues, meaning the ETF would simply get too big for the small underlying index it tracks.

All that glitters

This has happened with VanEck Vectors Junior Gold Miners (GDXJ). The ETF has had to widen the index it tracks as its assets under management (AUM) ballooned to around $4bn. One issue is that under Canadian rules, if a shareholder has a 20% stake in a company it has ‘to automatically extend a takeover offer to all remaining shareholders at the same terms,’ according to a Scotiabank report. GDXJ has 18% stakes in 10 Canadian companies so has to move fast.

From June, the MVIS Global JuniorGold Miners Index methodology will change to include mining companies with market caps between $75m and $2.9bn. This is a substantial increase from its prior range of $75m to $1.6bn.

In the interim the ETF is adding holdings from outside its index. These include shares in its big brother, the VanEck Vectors Gold Miners (GDX) ETF which has an average market cap of $9.3bn, hardly the territory of junior miners.

This is not the first time GDXJ has run into problems. Market Vector Index Solutions expanded the universe for the Junior Gold Miners Index after the ETF provider ran into similar problems in 2014. According to Scotiabank’s analysis, the 2014 change effectively doubled the market cap range.

Why index changes make sense

The amendments do not seem fair for investors who have picked a product purely for exposure to the junior gold mining universe. For Detlaf Glow, head of EMEA research at funds rating firm Lipper, this is preferable to the alternative. ‘Van Eck going really off benchmark with big bets is worse for investors than changing the index.

‘If you change the index you have a clear rule where you will invest. Then the investor can decide if they want to stay with that new index or not,’ he says.

A US-based manager for a large ETF provider who preferred not to be named, says: ‘We have conversations with index providers to make sure they’re building indices in the best interest of the investors’. However they say using holdings not contained within the index is fine as long as they produce a similar risk/return profile.

For US investors, there are plenty of ETFs that track small gold mining firms, for instance Sprott’s Junior Gold Miner ETF which has around $55m in AUM. UK investors do not have the same level of choice.

The risk of contagion

Van Eck’s problem may not be an isolated issue as there are other providers issuing ETFs that track niche but potentially popular indices. For example, something like iShares MSCI Frontier 100 ETF could have issues if the ratings agency, MSCI, reclassifies some of the countries the ETF tracks from a frontier rating to an emerging markets rating.

Glow says this would be more of an issue for the index provider than the ETF firm but adds it’s the investor most at risk.

One ETF provider who did not want to be named chooses index provider FTSE over MSCI as they view the countries in its emerging markets category as being more fitting. They say that South Korea, an emerging market under MSCI, is a developed market according to FTSE.

If an investor picks an emerging market ETF using MSCI indices that includes South Korea, and it is subsequently reclassified as a developed market, losing the sheer market capitalisation of the country will negatively impact the fund.

Ulimately, ETF providers face the dilemma of closing funds which have become too popular or as in Van Eck’s case change the respective benchmark. However, this might not go down with well with investors who could choose to sell the fund.

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