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Too Much of a Good Thing: What Happens When an ETF Outgrows Its Underlying Index?

VanEck Vectors® Junior Gold Miners ETF (GDXJ) made headlines this past April when it diverged from its benchmark of micro- and small-cap firms in the gold- and silver-mining industries and began acquiring the stocks of larger miners.

During the previous 17 months, GDXJ had grown from $1.2 billion in assets to more than $5.2 billion. That made it difficult for authorized participants—those entities tasked with obtaining an ETF’s underlying assets—to acquire adequate stakes in the small mining firms the fund required to efficiently track its index. Rather than halt the creation of new shares, GDXJ decided to accommodate stocks with bigger market caps—and in June its benchmark followed suit in order to eliminate the mismatch with its ETF.

GDXJ’s situation, while notable, isn’t all that surprising. ETFs that offer exposure to niche asset classes may outgrow their indexes if demand for new ETF shares increases beyond what the underlying securities can bear. When that happens, an ETF typically takes one of two tacks: It either stops issuing new shares or it deviates from its original benchmark, as GDXJ did in April.

In the first instance, high demand for an ETF’s existing shares could drive up its market price, causing the fund to trade at a premium.

In the second instance, adding nonindex holdings to an ETF could in turn alter the portfolios of its investors in ways that may no longer fit with their overall objectives.

So how do you know if your ETF is parting ways with its benchmark?

Warning signs

Schwab’s research has found that the ETFs most prone to outgrowing their indexes are those that hold:

  • International emerging-market and small-cap stocks, especially those focusing on a single sector.
  • International fixed income, especially local currency–denominated emerging-market bonds.
  • Target-maturity bonds, especially those with longer durations holding less-liquid sectors of the fixed income market.
     

If you own such an ETF and are concerned about it outgrowing its index, start by checking its holdings. Should the ETF begin investing outside its mandate, that could indiciate the authorized participants are having trouble acquiring the its target assets in sufficient quantities.

You might also monitor an ETF’s tracking difference, or the discrepancy between an ETF’s performance and that of its stated benchmark; a higher tracking difference could indicate the ETF is struggling to acquire stakes in its underlying securities.

Look before you leap

By and large, new shares of ETFs are created every day with relative ease. Nevertheless, as ETF providers continue to launch highly specialized products that tap into less-liquid corners of the market, index deviations may continue to occur.

When that happens, investors in an ETF that opts to diverge from its benchmark should reassess its place in their overall portfolios.

Those looking to join the stampede into an especially popular niche ETF, in particular, should examine the liquidity of the underlying securities—lest what you purchase today morph into something else entirely tomorrow.

Emily Doak, CFA®, is a senior research analyst at Charles Schwab Investment Advisory, Inc.

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Important Disclosures

Investors should carefully consider information contained in the prospectus or, if available, the summary prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Past performance is no guarantee of future results.

Investment returns and principal value will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares of ETFs  are bought and sold at market price, which may be higher or lower than the net asset value. Brokerage commissions will reduce returns.

All fund names and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell or a solicitation of an offer to buy any security.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Charles Schwab Investment Advisory, Inc., is an affiliate of Charles Schwab & Co., Inc.

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