In most industries, whether it be cars, jewelry, food or beverages, some products are built for scale and mass distribution, while others are niche and serve a distinct customer segment. However, some products simply aren’t meant for mass distribution, either due to the fact the product has naturally constrained production or, in the case of some products (e.g., branded retail), mass distribution would limit the good’s appeal. Most goods and services fall within the boundaries of infinite scale and uber-niche.
The ETF industry is no different.
Every ETF falls into one of those three categories:
- Built for scale,
- Niche products with limited scale, or…
- Something in between.
Any business or ETF can scale, but it often comes at the expense of quality (perceived and/or real). ETFs experiencing rapid growth in niche products experience a difficult decision at some point in their life cycle: Do they punt on their niche products and go for scale (potential to maximize profits, but may hurt performance)? Or do they make the decision to remain niche (may not maximize profits, but may maintain performance)? 1
In a previous post, I broke down all the ETF firms into divisions. We could do the same exercise here with individual ETFs: breaking all of them down into the three scale buckets above. However, given that there’s now approximately 2000 ETFs, this effort would be 1) a ton of work and 2) not that helpful for investors. Instead, I’m going to walk through the problems managers face so reader’s have the necessary educational toolkit to judge the scalability of any ETF that may come down the pipe — now or in the future. 2
The 1964 Supreme court case of Jacobellis v Ohio was to determine whether something is an obscenity or not (largely relating to pornography). United States Supreme Court Justice Potter Stewart was famously quoted as saying, “I know it when I see it.” Likewise, by the end of this post, you should be able to know the scale potential of various ETF strategies when you see them.
Let’s break this down.
Why Fund Managers Run into Scale Issues — Liquidity Problems
For active or passive fund managers, either in the mutual funds and/or exchange traded fund format, there can be scalability issues. When you’re managing $200 million, perhaps an investment strategy is able to generate outperformance. However, once assets begin flowing into a fund, it might be becomes more and more difficult for the manager to maintain the prior outperformance for a host of reasons.
Let’s use a simple example to illustrate:
Say ABC Asset Management has a strategy that has demonstrated outperformance. The strategy involves a 10 stock portfolio and all of the stocks in the portfolio have a $100 million market-cap– a $1 billion market-cap combined. Also assume that each stock trades 5% of its market cap per day, so $50 million notional trading volume in total for the combined portfolio.
What happens if the fund reaches $500 million in assets under management? You now own 50% of the combined market-cap! Also, if you traded $50 million in the fund, you would be using up the entire average daily liquidity.
Is this strategy going to continue work?
Not likely. Trading impact pressure from the fund manager will drive the prices of the individual companies up very quickly (perhaps higher than they are actually worth). Clearly, liquidity matters, especially for smaller, more concentrated portfolio strategies.
How Asset Managers Can Increase the Scalability of Their Funds
Faced with the problem outlined above, the asset manager would have two options:
- Close the fund to new investors before the manager reaches a liquidity problem.
When speaking with financial advisors, they tell me this is one of the more subtle advantages (well designed) ETFs provide for them. Let’s use small cap managers, as it’s the most typical example.
In the small cap space, by using highly scalable ETFs, an advisor doesn’t have to consistently find new small cap managers to put new client money to work. This is a sharp contrast to the active mutual fund space where once the advisor finally finds a good small cap manager, the fund often closes down to new investors shortly after. Or, perhaps even worse, the fund moves from being a small-cap manager to a mid-cap manager to increase its liquidity and scalability. Either way, it harms the financial advisor’s ability to run a consistent portfolio for their clients.
Using ETFs, an advisor can simplify their small-cap allocation. For example, the advisor can put all of their clients’ small cap allocation in the iShares Core S&P Small Cap ETF ($IJR) and have a consistent investment portfolio across the board for all of their clients. That means less time analyzing new investment managers, and more time to do other value add work for their clients (or to go find some new ones!). Of course, this might also mean giving up on identifying any edge that comes from identifying high performance managers. Win-some, lose-some.
- Alter the strategy to increase its scale.
There are two ways to do this for a fund. You can either increase the number of holdings within the fund, spreading the investor assets across a larger amount of individual holdings (and likely decreasing the potential returns of the fund, or “diworsify“). And/or, the manager can hold larger market-cap companies.
The Flexibility of Active Managers – A Blessing and a Curse
Active managers can change their strategies on the fly. As assets pour in, they can decide to now own 20 individual holdings (instead of the previous 10). They can choose to own five mid-cap companies and five small-cap companies (when they originally owned 10 small cap companies). Both of these solutions create more liquidity and enable a larger fund size.
But flexibility is a double-edged sword. The active manager is more adaptable, though the ability to change can lead to problems for active managers. Among many problems, it brings human emotions into play. 4 Our emotions often cause us to make poor investment decisions. Another problem with flexibility is that this can create style drift. For example, an investor might buy a value manager’s fund and check back one year later and learn that the fund is now a blend between value and growth to accommodate more capacity.
How can a rules-based process eliminate these problems? And how can they add scalability as part of their algorithm?
Rules-based processes eliminate flexibility because once the rules are set…they are set. You can’t easily change the rules and/or deviate from what the index your ETF is meant to track and the optics look bad.
As far as building in scalability, I’d recommend reading Dave Nadig’s piece at ETF.com. It’s a great piece outlining everything that goes into managing a passive ETF. That’ll give you a base for the discussion below.
Let’s look at how to build scale into a rules-based index.
Market Cap Weighted ETFs: The ultimate in scale
Most market capitalization weighted ETFs are the ultimate scale products. In SPY, the largest amount of your assets when you buy go into the largest, most liquid, name in the index: Apple. The smallest amount of your money goes into the smallest, least liquid holding in the index (currently News Corporation Class B Shares). With the iShares Core S&P Mid-Cap ETF ($IJH), which is market cap weighted and tracks the S&P 400 index, if there is a massive amount of inflows into the fund, the same thing happens (the largest amount of your money to the largest name, smallest to the smallest). But… there is a great self-correcting feature here if too much money is coming into this mid-cap fund due to the good design of these two indexes the fund’s track (S&P 500 and S&P 400, respectively).
Eventually, by adding so much money to IJH, investors would be pushing the market cap of that largest mid-cap holding up. In doing so, that stock would be moved to be a large cap company and placed in the S&P 500 index (where it’d be small weighting) and therefore returning the holdings of IJH back to a more pure mid-cap play. That is a simplification of the process, but highlights the basic idea of funds that have the built in ability to scale without having to change the rules or deviate from the index the ETF is meant to track.
The one area of market capitalization weighted ETFs that have the potential to run into scale issues are ones that focus on small niches. If the market cap weighted ETF holds only 30 names in a narrow industry, there’s more of a potential for the ETF to begin to distort the underlying stock prices as the fund size grows. For these types of ETFs, keep an eye on the fundamental valuations of the basket of securities, as well as the fundamental valuation of the ETF itself. If a utility sector ETF is trading at a 45 P/E and has $40 Billion in AUM, it might be a good idea to find income for your clients elsewhere (to use an extreme/obvious example).
Not Market Cap Weighted, but provide similar capacity
Some ETF strategies, while not market cap weighted, provide pretty close to the fund capacity of market cap weighted ETFs. They do that by using metrics that are highly correlated to the market capitalization of the company. WisdomTree’s earnings weighted funds are a good example of this.
Using the earning-weighting methodology as an example — the company with the largest earnings receives the largest weight, the company with the second largest earnings receives the second largest weight, etc.
The company that has the largest earnings, while not necessarily the largest company by market capitalization within the fund, will still be (on average) one of the largest companies within the fund, and therefore be a more liquid trading name. The company that has the smallest amount of earnings, while not necessarily the smallest company by market capitalization, will still be (on average) one of the smallest companies within the fund, and therefore be a less liquid name.
In short, most of your money is going to the more liquid names, less of your money is going to the less liquid names. That is good for scalability of a strategy.
Example of an ETF Strategy That Can Be Tweaked To Expand Capacity
A recent example of an ETF that tweaked its stated goal was the Van Eck Junior Gold Miners ETF($GDXJ). The fund grew in size beyond what it could handle from its original constituents, so they have begun to hold larger companies by market cap than what the name suggests. Sumit Roy went deep on that here.
This is a okay solution. But it is a good solution to a hard problem. An ETF company is incentivized to increase the assets under management in its fund. If the strategy becomes very popular, as GDXJ has, the ability to add capacity on the fly is a better alternative for investors in the fund than having no choice but to close a fund to new creations, or attempting to stick with the strategy and running into liquidity problems.
By moving up the average market cap holding of the fund, an ETF issuer can provide a slower change than the abrupt change of closing to new creations. Early investors in the fund experienced the ride of a fund that has matured. If a financial advisor decides they want to maintain their portfolio weighting to junior gold miners only, they can then take their time to sell the fund, or search for an ETF that provides a better solution for their needs.
More Difficult to Alter Rules
Some ETF strategies have a harder solution as their funds grow due to the lack of an obvious way to increase scalability. Let’s use an extreme hypothetical situation on the Guggenheim S&P 500 Equal Weighted ETF ($RSP).
Say you’re a massive institutional investor and you wanted to put $500 billion into that fund and have them be your sole large cap holding.
Could you do it?
No — you couldn’t.
But why not?
With an equal weighted strategy, you’re putting the same amount into Apple (the largest company in the S&P 500 by market cap) as you are AutoNation Inc. (the second smallest company in the S&P 500 by market cap). With a $500 billion trade, you’re placing $1 billion into each company in the S&P 500. AutoNation Inc. has a market cap of about $4 billion. You’d be buying about 25% of the company in one fell swoop. To state the obvious, that would massively drive up the price of the shares and create a very dislocated trade.
Now, there’s probably no firm in the world that can or would take a $500 billion position in any single ETF, but this example highlights a potential issue with equal-weighting.
Equal weighting is difficult to tweak (in order to increase capacity) because you’re only option to expand capacity is to increase the number of holdings. In this case, the only option would be to add more mid cap companies (as the S&P 500 already owns almost all of the investable large cap companies). By adding more mid-cap companies, you’re not exactly adding much capacity.
How to Monitor If An ETF is Approaching Scale Issues
This is unfortunately more art than science. There’s no tried and true rules I can give you, besides the obvious.
If an ETF is closed to new creations, that’s a sure sign the strategy has hit their max scale (thanks, Captain Obvious!). If you own an ETF that this happens to, investigate if the closure, or limiting, to new creations is temporary or permanent. We’ve seen this happen with China A Shares ETFs as the US asset managers running the funds are restricted as to how much an allocation of the underlying stocks they can own. When funds that track the China A Shares market run out of their allocation due to their funds growing in size, they are forced to close down to new creations. 5
Another thing to watch–ETFs with a massive rush of assets flowing into the fund. Usually you’re looking out for multi-billions dollar flows into the less-scalable strategy types mentioned above. Seeing multiple billions of dollars flowing into a fund strategy does not mean it will be pushed beyond its scale, but it is something to be aware of in your quarterly check up (or however often you think is best) on your funds. For example — Did you buy the fund a year ago and there was $500 million in the fund, and now there’s $5 billion? In this case, it’s worth digging a little deeper on and referencing some of the above points.
The last thing to keep an eye on is the general valuation on the funds strategy. This ties into the above point–if there is a large rush of assets into a strategy, it’s possible the popularity of the strategy has pushed the assets in that strategy beyond their historical norms. That type of demand can distort asset prices if it’s big enough.
We’ll continue to see ETFs being built that have all different types of scale. This difference in product is good for the market. Often, the best strategies can be the ones that don’t scale as well as others. As many have said, you can’t beat the market if you are the market. This is a reason to continue looking at those smaller AUM ETFs. The tough thing is figuring out which of those new strategies is real and which ones are a gimmick. In that case (as many have also said), if it was easy, everyone would do it!
- See Wes’s post in the WSJ on this potential conflict of interest. ↩
- Wes has a great post looking at this using hard data for certain investment strategies. ↩
- Note this option is mainly used by mutual funds. ↩
- Note that some “active” managers may use a quantitative model to develop the stock names, thus eliminating the human emotion component ↩
- Note — If youre in a situation with a closed down fund and want to get out of the fund, the best thing you can do is either reach out directly to the ETF company managing the fund or to a trading partner of yours who is experienced in trading ETFs. ↩