What happens when an ETF gets too big for its index?

This is not a hypothetical question.

Last month it was reported that the Junior Gold Miners ETF (GDXJ) had amassed $5.4 billion in assets, a level too large for its index. In order to avoid exceeding 20% ownership in a few of its holdings (which under Canadian rules would necessitate a takeover offer) and abide by IRS diversification requirements (which would jeopardize its preferential tax treatment), it was already deviating from its index, and by no small amount.

Five of its holdings (25% of its assets) were outside the index, including a position in another Gold Miner ETF: GDX (its 2nd largest holding).

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VanEck (manager of GDXJ) responded by announcing changes to the ETF/Index starting on June 17. The new index will increase the market cap range of the underlying universe from a maximum of $1.6 billion to a maximum of $2.9 billion. This would result in 23 new companies being added to the index that could “represent as much as 60.8% of the new portfolio.”

How have market participants responded?

None too kindly. One of the top performing assets early in the year, GDXJ has declined 20% since the announcement.

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Investors don’t seem to be waiting for the changes to take place, with over $625 million in outflows since the announcement. That combined with the decline in share price has brought the AUM of the GDXJ ETF down to $4 billion (from $5.4 billion at the time of the announcement).

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Given the existing rules, VanEck had little choice in making the changes. But ironically, if these outflows continue, GDXJ may no longer be “too big for its index” by the time the index is changed. Perhaps the market would have eventually solved the issue on its own, by good old-fashioned supply and demand.

The broader question from this story is as follows: with the continued explosion of ETF/Index assets, will this soon become an industry-wide problem? I don’t believe so, at least not anytime soon. There will likely be other niche ETFs that face similar issues, but the largest broad-market ETFs (total stock and bond market) are a long way from outgrowing their indices:

• The largest ETF in existence, SPY (S&P 500), has $238 billion in assets. The total market cap of the S&P 500 is over $21 trillion. So SPY is a little over 1% of the value of the S&P 500.
• The largest bond ETF in existence, AGG (U.S. Aggregate Bonds), has $44 billion in assets, roughly 0.2% of the value of its index.

By comparison, at $5.4 billion, the Junior Gold Miner ETF was 18% of its benchmark universe.

In a future post, I’ll dig into this in more detail, examining other popular niche ETFs. But for broadly diversified ETF investors, the notion that GDXJ is a microcosm of the industry at large is patently false.