What’s in your ETF?

As passive investing pulls in ever more money from active funds, we're seeing plenty of scaremongering about the "dangers" of trackers and exchange-traded funds (ETFs). Much of this reflects the active fund industry's straw-clutching efforts to discredit low-cost rivals. But there are some things to be aware of, as problems with one popular ETF earlier this month revealed.

The VanEck Junior Gold Miners ETF (listed in both the US and the UK under the ticker GDXJ) tracks the MVIS Global Junior Gold Miners index (VanEck also owns the index provider, MVIS). As MoneyWeek readers probably know, gold miners have done very well since the start of 2016. As a result, this ETF has grown rapidly. It started 2016 with total assets of around $1bn. It's now worth more than $5bn partly due to rising share prices, but mainly due to the $3.3bn that has flooded into the ETF over that time.

The ETF is now one of the biggest in its sector. However, the index it tracks is full of small, speculative companies, around 75% of which are listed in Canada. If you pump a lot of money into a small market (in total, the investable universe is worth around $30bn, according to one analyst), you end up owning a lot of the index. There are now ten stocks where the ETF now owns more than 18% of the shares outstanding, according to Scotiabank. Under Canada's listing rules, once you own more than 20% of a company's shares, you have to make a takeover offer for the rest.

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Clearly, that's not practical. As a result, VanEck is expanding the range of stocks the index will track. It will now include stocks with a market capitalisation of up to $2.9bn, says Sumit Roy of ETF.com, nearly twice the original $1.6bn. That solves the size problem. But it's not necessarily great for investors. Firstly, rebalancing buying the new index members means selling big chunks of existing ones. Those miners' share prices fell in anticipation, says Roy "GDXJ dropped notably" on news of the change, even on a day that gold prices climbed (normally positive for gold miners).

That's a temporary problem. A bigger one is that if you bought GDXJ (I own a bit myself), then presumably you did so because you want to own small-cap gold miners. Instead, you now own something closer to a mid-cap gold fund. You may be happy with that. But at the very least, you need to know about it. This problem of shifting holdings is hardly unique to ETFs active managers often experience strategy "drift" over time. But it's a reminder that, whatever you invest in, you must ensure that you know what it does, and review its performance often enough to ensure that it actually does it.

Beware of gremlins in exotic corners of the market

The GDXJ ETF (see above) also raises the question of what can happen when ETFs interact with each other. The Direxion Daily Junior Gold Miners Index Bull 3X Shares (JNUG) delivers three times the daily move in the same underlying index as GDXJ. In short, if you want to take an aggressive short-term bet on small gold miners, this is the ETF for you. Buying it is fraught with risks.

JNUG is a bet on a specific gold mining index, not the gold price; and it's rebalanced daily, so if you hold for more than a day at a time, the results will diverge from the underlying index. Say the index starts at 100. On day one, it rises by two points (2%) to 102. On day two, it falls by five points (4.9%) to 97. On day three, it rises by three points (3.1%) to 100. Overall, it's unchanged. Yet a triple-leveraged ETF would perform very differently. On day one, it would gain 6%, to give you £106 on a £100 investment. On day two, it would shed 14.7%, leaving you on £90.40. On day three, it rises by 9.3%. So you end up with £98.80 or so down 1.2%.

But the interaction between JNUG and GDXJ adds a potential further layer of risk. JNUG has proved a popular punt as gold-mining shares rise. Yet this may have contributed to GDXJ's problems, says Sumit Roy of ETF.com. Analysts reckon more than half of GDXJ's shares are owned as hedges against the swaps underlying JNUG put simply, when investors buy JNUG, it drives up demand for GSXJ too. So JNUG's popularity has helped force GDXJ to expand its index, resulting in a sell-off in GDXJ, which in turn hit JNUG holders largely for mechanical reasons that few investors can understand, let alone predict. This is just a small corner of the ETF universe, of course. But don't be surprised to see similar issues in other exotic areas.