Forget Liquidity, ‘Capacity’ Is Real ETF Concern

April 26, 2017

Not An Isolated Event

Some met this story with a shrug. The junior gold mining space is not large—about $30 billion by some measures—so the idea that a $4.8 billion fund covering it was starting to hit ownership caps and was having trouble investing the new assets didn’t seem strange. The fund’s assets under management (AUM) have grown from $1 billion in early 2016 to the current $4.8 billion today.

And it is indeed not strange. In fact, we have seen similar changes to indexes in other small-cap equity funds, which grew so large they, too, bought bigger companies than originally intended. There can be overlaps between the small-cap and the midcap space, even into the large-cap.

Next 'Capacity' Frontier

Reuters also recently reported on how frontier equity indexes are about to lose some of their biggest and most liquid markets as they potentially move to emerging market status—Pakistan, Nigeria and Argentina are all in line for a promotion—which means funds based on these indexes will have fewer investable stocks.

"The index is already a little bit skewed and not very attractive as a basket of stocks to invest in ... The removal of Pakistan, and maybe Argentina will make it more and more irrelevant," George Birch Reynardson, who runs a frontier fund at Somerset Capital, told Reuters.

Here the potential capacity problem for a fund like the $580 million iShares MSCI Frontier 100 ETF (FM) is that it would lose its second- and third-biggest constituents in Argentina and Pakistan, with weightings of 20% and 10%, respectively, as well its eighth-largest country in Nigeria, at 4%. Those positions will be sold and will have to be reinvested. But where? The liquidity issue here will be too much of it and too few things to buy.

Capacity Problem In Fixed Income

Back when Bill Gross was running PIMCO’s Total Return Fund, there was always talk that maybe the fund, with nearly $300 billion in AUM at one point, had grown too big. Because of its size, the fund had made many bets using derivatives, and had such large positions in sovereign debt from countries like Spain and Italy, that it would have been difficult for the fund to quickly unwind positions.

The worry grew when Gross left PIMCO, and some speculated that if investors ran to the exits in droves, fulfilling redemptions could prove difficult. But time has proven they could indeed unwind positions and meet redemptions, but the capacity concern always hovered.

The capacity concern in the ETF industry is a good problem, you could say. It is a symptom of success in attracting assets.


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