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 recently as high as $36.71, an 85 percent 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.
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 the ETF owns where its ownership percentage is more than 18 percent.
For six of those companies, the percentage would be even greater, but presumably, the fund doesn't want to exceed the 20 percent 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.
GDXJ assets under management
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 percent 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 non-index 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.