Both shady components becoming dominant within an ETF or the entire ETF becoming too dominant ("the tail wagging the dog") in a sector are issues to look out for when choosing a niche / sector ETF.
Two recent examples: GDXJ (junior gold miners) and TAN (solar).
The issue of over-powering sector ETFs will - given the general growth of the ETF industry and sector / niche ETFs in particular - become more and more important:
Earlier this week, ETF.com reported that the VanEck Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ) may have become too big for its index, the MVIS Global Junior Gold Miners Index. The $5.4 billion exchange-traded fund owns giant positions in its underlying holdings, putting it at risk of violating certain Canadian and U.S. regulatory thresholds.
To avoid crossing those thresholds, the ETF bought up stocks of companies that aren't in its index―creating a significant divergence between the ETF components and the index components. On Thursday, VanEck (which runs both the ETF and index) acknowledged the divergence by announcing it would broaden the scope of the index and include many more gold miner stocks in the portfolio at the next rebalance date.
This Bloomberg headline sums up the issue nicely:
'Curse of Success' Leads the Most Popular Mining ETF to Widen Its Holdings
"This is a broad perception that ETFs are the easy way to invest in a theme without devoting the time and effort to analyze the individual component firms," said Alan Gayle, a senior strategist who helps oversee $42 billion in assets at RidgeWorth Investments in Atlanta. "As ETFs penetrate smaller and more specialized themes, they run the risk of actually distorting the market they are trying to mimic."
To be continued in other sectors or niches with a dominant ETF. This was certainly not the last example.
Many ETF investors tend to have more of a "buy and hold" mentality, but keeping up with the ETF's contents - also because of possible bad apples within an ETF (more on this below) - from time to time is important.
See this solar ETF's (NYSEARCA:TAN) example with a growing dubious Chinese position some time ago I discussed this in a separate SA blog entry at the time:
Hanergy: A Warning About A Major Guggenheim Solar ETF Component
The Hong Kong exchange still seems to have a quite a lot of these smaller caps (with either obscene bid-ask gaps or wild swings and obscene market caps with little to no liquidity) listed:
A 9,800% Stock Increase Exposes Hong Kong's Billionaires on Paper
- A dozen billionaires can't sell shares at the value they trade
- SFC warns about companies with $80 billion total market value
It is - or should be - the ETF's creator (or before that the index composer's on which the particular ETF is constructed) job to make sure such companies aren't part of the ETF or the index in the first place.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I had long positions in both GDXJ and TAN in the past. I might open a new long position in TAN in 2017, especially when shorting single solar stocks.