Here’s What Happens When An ETF Gets Too Big

May 4, 2017

Here’s What Happens When An ETF Gets Too Big

  • When an ETF owns more than 10% of a company, any kind of rebalancing can be very dangerous for the stock.
  • The VanEck Vectors Junior Gold Miners ETF is becoming too big for its index, and has been forced to look beyond junior miners and to sell up to 50% of some of its positions in order to rebalance.
  • The main danger coming from ETFs is the lack of underlying liquidity, especially when there is no one to buy the assets sold in a fire sale.

Introduction

ETFs are potential vehicles of mass destruction. There is a high chance that in a few years from now, we’ll be talking about the 2000 dot-com bubble, the 2009 subprime crisis, and the 201X ETF liquidity crisis.

After ETFs took the investment stage, there weren’t many issues with them as they remained relatively small. However, the continuous inflow of capital has already made some ETFs too big.

In today’s article, we’ll describe the issue with the VanEck Vectors Junior Gold Miners ETF (NYSEARCA: GDXJ) and how it’s affecting index constituents.

The Van Eck Vectors Junior Gold Miners ETF Has Gotten Too Big

You might wonder how getting too big could ever be a problem. Well, increased capital inflows made the GDXJ ETF own too much of certain stocks. GDXJ quickly became the largest shareholder of several companies and owned almost 20% of 5 junior miners. Under Canadian law, if an ETF passes the 20% ownership mark, it would be forced to make a buyout offer for the company which isn’t the business of ETFs. This situation forced GDXJ to deviate from the underlying index and ultimately buy companies that aren’t part of the index and not even small cap junior miners.

As junior gold miners aren’t big companies and with GDXJ recently reaching $5 billion in assets under management, it really makes it the elephant in the $30 billion junior gold mining room.


Figure 1: GDXJ has seen a five-fold increase in assets under management in the last year. Source: Bloomberg.

The solution to the problem for GDXJ was to step out of the junior miners’ world and into larger miners. The company announced it would now buy into companies with a maximum market cap of $5 billion, up from $2.5 billion. This will create a complete new index and force GDXJ to sell almost 50% of some of its current positions in order to rebalance by adding larger miners.

As an ETF, GDXJ moves slowly and plans to rebalance in June. However, hedge funds already have smelled blood and acted immediately by shorting the GDXJ holdings that will be reduced given that it will be easy to buy them back when the GDXJ starts selling in June. This situation made the GDXJ ETF fall almost 20% in less than a few weeks.


Figure 2: The GDXJ ETF keeps on declining. Source: Nasdaq.

Some junior miners the ETF has a large position in are especially under pressure. For example, DRDGold (NYSE: DRD) makes up only 0.7% of the GDXJ ETF, but GDXJ owns 12% of DRD. As GDXJ will be forced to sell almost 50% of its stake in DRD to properly rebalance toward larger miners, it’s logical to expect pressure on DRD’s stock price. Since the beginning of April, DRD is down almost 30%.


Figure 3: DRDGold and other junior miners are under heavy fire. Source: Nasdaq.

If you want to own a junior miner and buy it on the cheap, take the holdings list of GDXJ and look for companies that are junior miners with a low market capitalization and are more than 10% owned by GDXJ. As the GDXJ rebalances and shorts have a party, given the small market capitalization and huge rebalancing, there might be excellent buying opportunities on the horizon.

Conclusion

Now, we’re talking about a secondary, highly risky market here where the problem is forced selling due to too much interest. I can’t even imagine what will happen to the market when ETFs become forced to sell assets due a bear market increasing redemptions or any kind of liquidity bond crisis in fixed income ETFs. You can read more about the risk of high yield ETFs here.

The main point of this article is that those who invest in businesses will be faced with amazing investing opportunities as some ETFs falter. However it’s impossible to know how low a stock can go as a result of ETFs selling. Buying cheap with a margin of safety will provide excellent returns in the long run as the company won’t be affected by its market price, if it doesn’t need to raise capital by issuing shares of course.

On the contrary, if you prefer to buy ETFs, be sure to do proper due diligence as ETFs aren’t really buy and forget it vehicles. There are lots of distortions due to capital inflows and outflows that might make you own something completely different than what you thought you were buying which is exactly what happened with GDXJ. As we’ve discussed above, those who thought they’d own a well-diversified basket of junior miners by buying GDXJ already find themselves with a basket that includes 25% larger miners with the percentage increasing fast.

If you really want to be exposed to junior gold miners, it’s cheaper and more efficient to buy 5 to 10 companies yourself than to go through an ETF. And on top of it, you can choose the holdings in relation to your risk profile, i.e. a low-cost miner for a risk averse investors, or a marginal cost miner for an investor with more appetite for risk.

By Sven Carlin Commodities ETFs Gold Investiv Daily Share: