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How An ETF Gets Too Big For Its Index

Sumit Roy

Can an exchange-traded fund get too big for its index? That's the question investors in one popular gold miner ETF are grappling with after rapid asset growth pushed it to significantly deviate from its underlying index.

The ETF in question is the VanEck Junior Gold Miners ETF (GDXJ), which tracks the MVIS Global Junior Gold Miners Index. Since early 2016, assets in the fund ballooned from a little more than $1 billion to $5.4 billion currently. Some of that was due to rising share prices―GDXJ nearly doubled from $19.80 at the start of 2016 to $36.71 today, an 85% gain, thanks to the rebound in gold.

But a lot of it had to do with the enormous amount of new money that came into the fund. Since Jan. 1, 2016, inflows into the ETF have totaled $3.3 billion. For almost any ETF, that's a big amount, but especially for one that targets a relatively niche area like junior gold miners.

GDXJ Assets Under Management

Source: Bloomberg

Giant Stakes In Underlying Holdings
The ETF has gotten so big that it now owns giant stakes in its underlying holdings, three-quarters of which are Canadian companies. According to an analysis by Scotiabank, there are 10 Canadian companies that the ETF owns where its ownership percentage is more than 18%.

For six of those companies, the percentage would be even greater, but presumably, the fund doesn't want to exceed the 20% level, which, under Canadian rules, would force the ETF "to automatically extend a takeover offer to all remaining shareholders at the same terms," according to a Scotiabank report.

The ETF has also struggled to abide by U.S. IRS diversification requirements. "GDXJ has intermittently been in jeopardy of losing its preferential tax treatment (as a regulated investment company) since last September because its portfolio often doesn’t comply with the diversification requirements of the U.S. Internal Revenue Code," noted Scotiabank.

 

ETF Deviating From Index
In an attempt to try to ameliorate the concentration issues it’s facing, the ETF now has five holdings that aren't index constituents, representing 25% of GDXJ's portfolio, according to BMO Capital Markets. One of those holdings is the VanEck Vectors Gold Miners ETF (GDX), another product from the same issuer, which focuses on much larger gold companies.

Chris Kwan, mining specialist at BMO, believes GDXJ has simply gotten too big for its benchmark now that it is a $5 billion ETF "attempting to invest in a ~$30B gold universe."

In Kwan's view, there are three ways forward for the ETF. It could continue with the status quo, creating uncertain and volatile quarterly rebalances; it could sell its nonindex gold stocks and increase its position in GDX; or it could expand the allowable market-cap size of the ETF.

Moving Beyond Junior Gold Miner Territory

In a way, the ETF has already de facto expanded the average size of its holdings. The nonindex names that it owns have the biggest weightings in the fund. That includes GDX, which has a weighted average market cap of $9.3 billion―well beyond small-cap, junior miner territory.

Perhaps the easiest fix for VanEck, which also develops the underlying index for GDXJ, is to expand what it considers to be the junior gold miner universe, something the issuer did in 2014 when faced with a similar situation. Why hasn't this happened already? That may be because the portfolio managers are holding out hope that, at some point, they can go back to employing a full replication strategy.

As Scotiabank points out, if VanEck expands the universe too much, the market cap for some of the holdings in the ETF would breach $2.5 billion, a level often used to define small-cap stocks. That's not necessarily a horrible thing, but it would take the ETF further away from offering the junior gold miner exposure that it promises.

VanEck wouldn't comment on its portfolio management decisions for this story, but said that "it continues to manage GDXJ so it meets its investment objective" even though "there may be times when certain market and regulatory factors affect the ability of GDXJ to own certain securities or own them in proportion to their index weightings."

 

JNUG Tail Wagging The GDXJ Dog

Of course, if asset growth for GDXJ remains strong, the issuer may have little choice but to broaden the scope of the ETF. What's interesting is that much of GDXJ's recent (and perhaps future) growth has come from an unlikely source: the Direxion Daily Junior Gold Miners Index Bull 3X Shares (JNUG).

Analysts at Scotiabank believe that most of the growth in GDXJ was due to inflows into JNUG, which offers 3x leveraged exposure to the same underlying index as GDXJ. Since early last year, JNUG has seen its assets rise from $100 million to more than $1 billion currently.

The analysts pointed out that according to the latest daily holdings report from JNUG, "nearly 53% of GDXJ’s shares outstanding could be held as hedges against swaps that underlie the 3x levered product."

That's an interesting twist in this saga if JNUG is the tail that’s wagging the GDXJ dog.

Bottom Line

For investors, the bottom line is that the holdings of their favorite junior gold miner ETF have gotten a little bit bigger on the market-cap spectrum. It's not necessarily a huge deal, but for those aggressive investors looking for targeted exposure to the smallest, most volatile gold miners, perhaps that's something that turns them off from the fund and compels them to look elsewhere.

On the other hand, GDXJ is by far the most liquid and tradable name in the junior gold miner space, and a marginal increase in its weighted average market cap isn't going to noticeably change the volatility of the fund or the exposure it offers.

Contact Sumit Roy at sroy@etf.com

 

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