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May 8, 2017

Monday Morning Memo: Is Capacity a New Restriction for the ETF Industry?

by Detlef Glow.

The European exchange-traded fund (ETF) industry has truly written a growth story over the last 16 years. The steadily increasing assets under management have led to a number of discussions about the impact of the ETF industry on the markets. Some market observers have raised concerns about the markets covered by ETFs, especially in the bond segment, since a number of bonds—even though they are in a benchmark— do not have sufficient liquidity to be traded in huge quantities. Even though the liquidity issue is valid, ETF promoters in Europe have found ways to overcome this limitation with so-called optimized sampling models.

Graph1: Assets Under Management in the European ETF Industry (in bn euro)

Assets Under Management in the European ETF Industry (in bn euro)

Source Lipper

In April 2017 a new issue for ETFs was raised in the United States when Sumit Roy reported on that VanEck Vectors Junior Gold Miners ETF might have become too large for its index. The ETF industry has faced the same issue that many active fund managers get questions about: the capacity of their funds/strategies. I asked this question of Dr. Bert Flossbach during an interview we conducted in March 2017 as the flagship fund of the company grew to more than 11 billion euros in assets under management. Dr. Flossbach answered that he doesn’t see any restrictions caused by the increased assets under management. He thinks this question is more a topic for passive funds than for active managers in the multi-asset segment. ETFs have to cope with higher assets under management in comparably smaller market segments.

The trouble for VanEck Vectors Junior Gold Miners ETF did not arise because the fund couldn’t buy the stocks it needed for replication of the index; it came from the fact that the fund has built up giant positions in some constituents of the index. Since the fund wanted to avoid making a takeover offer to the remaining shareholders, as requested by regulators when an investor hits a given threshold (in this case 20% of the outstanding shares, under Canadian rules), the fund management decided to buy stocks that aren’t in the benchmark to broaden the investment universe. This obviously led to a deviation of the fund compared to its benchmark, which is not in the favor of investors. In his article ’Forget Liquidity, ‘Capacity’ Is Real ETF Concern Drew Voros pointed out that the capacity issue is not only a topic for small-caps and sector funds; markets as a whole (such as the so-called frontier markets) can become too small when an ETF tracking the respective index becomes popular with investors. But what can an ETF manager do to avoid capacity issues?

The answer to this question is not as simple as it may seem, since a niche/small market can’t be increased by broadening the investment universe; that may change the risk/return profile massively. When market indices such as the Dow Jones Industrial Average or the S&P 500 Index were first published, there was no need to take factors such as diversification or liquidity into account, since nobody planned to invest in these indices; they were simply measures to evaluate the status of the stock market. This has changed massively over time; index investments have become very popular, and more and more money has flown into funds that track indices. The upcoming rules on diversification for mutual funds—for example those under the UCITS regime—and limitations on the availability of some securities have led index promoters to new methodologies for index construction that take these new requirements from investors into account and make the respective indices more investable. That said, some indices—especially in the bond segment—still contain constituents that face liquidity issues; these securities can’t be traded in the large quantities that might be needed by some index products. As mentioned above, ETF promoters have developed optimized sampling replication methodologies to avoid those securities or to minimize transaction costs in broad indices such as the S&P 500 or the MSCI World. But those methodologies can’t prevent them from hitting thresholds on the size of single positions when the assets under management rise too far. Investing off benchmark is also not a sufficient solution, since that may cause a high tracking error between the fund and its benchmark or raise other concerns from investors.

ETF promoters will be responsible for handling the upcoming capacity issues. What sounds simple is not an easy task, since ETF promoters want to earn money. Fulfilling this task appropriately could mean an ETF promoter has to close a bestselling fund because of the capacity issues of the underlying market. Or, the promoter may need to change the benchmark of the fund, which might not be in the favor of investors and may lead the investors to sell the fund.

The views expressed are the views of the author, not necessarily those of Refinitiv.

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