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Forget liquidity, ‘capacity’ is real ETF concern

You're in an elevator and it starts getting really crowded. You instinctively look over to the conveyance permit for the weight capacity of the lift. You count the number of people and multiply by, say, 150 pounds to see how close it is to capacity.

Chuck Savage | Getty Images

That's sort of analogous to what concerns some in the ETF industry.

Capacity is currently much more of a concern for ETF issuers and portfolio managers than the much-talked-about myth of ETF liquidity. With the flood of new assets flowing into the ETF space — from $1.2 trillion five years ago to $2.8 trillion today — the concern that an ETF could get too big is not only prevalent, but has just played out again.

This month, ETF.com's Sumit Roy reported on how the VanEck Vectors Junior Gold Miners ETF (GDXJ) had become too big for its index, the MVIS Global Junior Gold Miners Index. The $4.8 billion ETF owns giant positions in its underlying holdings, putting it at risk of violating certain Canadian and U.S. regulatory thresholds for corporate ownership.

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To avoid crossing those thresholds as more assets piled into the fund, the ETF bought up stocks of companies that weren't in its index — creating a significant divergence between the ETF components and the index components.

VanEck (which runs both the ETF and the index) recently acknowledged the divergence by announcing it would broaden the scope of the index and include many more gold miner stocks in the portfolio at the next rebalance date.

What VanEck is doing is expanding the size of the potential pool of constituents by taking on bigger companies. Whereas the market-cap range of companies was $75 million - $1.6 billion previously, going forward, it will be $75 million - $2.9 billion. The fund is taking a step toward the midcap space as it runs out of small-caps to buy.

Not an isolated event

Some met this story with a shrug. The junior gold mining space is not large—about $30 billion by some measures—so the idea that a $4.8 billion fund covering it was starting to hit ownership caps and was having trouble investing the new assets didn't seem strange. The fund's assets under management (AUM) have grown from $1 billion in early 2016 to the current $4.8 billion today.

And it is indeed not strange. In fact, we have seen similar changes to indexes in other small-cap equity funds, which grew so large they, too, bought bigger companies than originally intended. There can be overlaps between the small-cap and the midcap space, even into the large-cap.

Next 'capacity' frontier

Reuters also recently reported on how frontier equity indexes are about to lose some of their biggest and most liquid markets as they potentially move to emerging market status—Pakistan, Nigeria and Argentina are all in line for a promotion—which means funds based on these indexes will have fewer investable stocks.

"The index is already a little bit skewed and not very attractive as a basket of stocks to invest in ... The removal of Pakistan, and maybe Argentina will make it more and more irrelevant," George Birch Reynardson, who runs a frontier fund at Somerset Capital, told Reuters.

Here the potential capacity problem for a fund like the $580 million iShares MSCI Frontier 100 ETF (FM) is that it would lose its second- and third-biggest constituents in Argentina and Pakistan, with weightings of 20 percent and 10 percent, respectively, as well its eighth-largest country in Nigeria, at 4 percent. Those positions will be sold and will have to be reinvested. But where? The liquidity issue here will be too much of it and too few things to buy.

Back when Bill Gross was running PIMCO's Total Return Fund, there was always talk that maybe the fund, with nearly $300 billion in AUM at one point, had grown too big. Because of its size, the fund had made many bets using derivatives, and had such large positions in sovereign debt from countries like Spain and Italy, that it would have been difficult for the fund to quickly unwind positions.

The worry grew when Gross left PIMCO, and some speculated that if investors ran to the exits in droves, fulfilling redemptions could prove difficult. But time has proven they could indeed unwind positions and meet redemptions, but the capacity concern always hovered.

The capacity concern in the ETF industry is a good problem, you could say. It is a symptom of success in attracting assets.

The real liquidity issue

Still, few talk about capacity. There is, however, a lot of talk about liquidity. But the real liquidity issue lies in the asset classes that ETFs cover, and just how big and liquid they are to accommodate big and growing ETFs.

"The less liquid the asset class and the bigger the fund, the more you're going to run into these issues," said Jim Wiandt, founder of ETF.com, and now a consultant in the industry. "They're becoming increasingly common in the ETF space, because some of these funds have just gotten so big, that even in asset classes where you really didn't have capacity problems in the past, you're starting to get a little bit of a tilting of the tables."

But herein also lies opportunity. For issuers with smaller funds that watch their competitors grow so big they need to bend their index, this could open the door for new assets.

Returning to the junior gold miner space, there are other funds that continue to focus on smaller firms. As GDXJ lifts its market-cap average, a fund like the Sprott Junior Gold Miners ETF (SGDJ), with $55 million in AUM, could pitch itself as the true junior gold miner ETF, since it keeps its market-cap parameters between $250 million and $2 billion. The same could be said with the $44 million Global X Gold Explorers ETF (GOEX), which has a similar range as SGDJ, of $200 million - $2.4 billion.

So the buzzword to pay attention to going forward is "capacity." Know when your fund is getting so big that it's changing its index. That could mean a significant change in what you're investing in, and maybe the signal that it's time for you to get off the elevator.

By Drew Voros, editor-in-chief, ETF.com