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How a $1.4 Billion ETF Gold Rush Rattled Mining Stocks Around the World

23 Apr 2017 12:00 pm
By Asjylyn Loder and Chris Dieterich 

Unruly trading in the shares of some small gold companies is rekindling investor concern about the pressure that fast-growing passive funds can exert on the stocks they are meant to track.

In the past six months, waves of money rushed into a $20 billion complex of interlinked exchange-traded funds that invest in gold-mining companies. The flows prompted the ETFs to amass ever-larger stakes in dozens of small firms. Efforts to check the funds' growth triggered price gyrations in gold stocks from Sydney to Toronto, at a time when the price of gold was largely flat.

The turmoil illustrates how the rise of index investing could rattle trading in the years ahead, especially as the $4.8 trillion ETF industry sprawls into smaller markets, investors said.

"ETFs can move stocks, and that is what's going to happen when investors flock into funds that hold small- and microcaps," said Neil Leeson, research director at Spyglass Trading in Dallas.

In the past decade, ETFs have been blamed for unusual price swings in oil, utility stocks and high-yield debt. Just this month, a flood of cash into a new Canadian ETF jolted trading in the nascent marijuana industry, and in September, the Bank of Japan curbed its purchases of ETFs pegged to the Nikkei 225 index after its stimulus efforts distorted prices.

Encouraged by lower fees and subpar performance of active managers, investors have pulled $304.7 billion from active U.S. funds in the past 15 months as passive products gained $735.5 billion, according to Morningstar Inc.

Whether the shift to passive investing helps or hurts markets is a hot-button issue in the financial industry. Some studies suggest stocks included in popular indexes sport higher valuations and tend to move in lockstep with one another instead of responding to fundamentals. Others contend ETFs buffer markets in times of stress.

"There's definitely the possibility for some issues to arise, but in the vast majority of cases we're a long way off," said Ben Johnson, head of ETF research at Morningstar, pointing out that ETFs in larger markets don't come close to dominating trading the way the gold mining ETFs did recently.

The most recent example of an ETF knocking prices out of whack centers on the VanEck Vectors Junior Gold Miners ETF, which invests in small gold companies. The ETF has taken in $1.4 billion since September, forcing VanEck to hoover up mining shares.

Juicing its growth was the Direxion Daily Junior Gold Miners Index Bull 3X ETF, which uses the VanEck ETF to give investors a triple-leveraged bet. For each $1 dollar Direxion took in, it funneled $3 into the VanEck fund.

VanEck plowed that cash back into gold stocks, becoming the largest investor in two-thirds of the 54 companies the ETF owns shares in, according to FactSet. In some cases, VanEck owned 16% or more of the available shares of those companies, bringing it into the range of a Canadian securities law that requires firms that exceed a 20% stake to offer a buyout to the remaining shareholders.

"We continuously monitor the portfolio," said Ed Lopez, head of ETF product management for Van Eck. "Our primary concern is that we're meeting our investment objective."

With more money coming in than it could invest in its roster of gold miners, the VanEck junior ETF directed some of the overflow into the VanEck Vectors Gold Miners ETF, which invests in larger firms. That ETF swelled to $12.5 billion amid the combined inflows from its smaller sibling and the Direxion Daily Gold Miners Index Bull 3X ETF, another leveraged copycat.

As the ETFs overran the market, more traders piled in. On April 12, Direxion received orders for $113 million in new shares of its leveraged junior ETF, the largest inflow in its history. The next day, Direxion closed the fund to new investors "until further notice." The ETF's share price rose higher than the value of its assets, reflecting the imbalance of demand over suddenly finite supply.

"We wanted to be sure we weren't exacerbating the issue of the products growing too fast," said Sylvia Jablonski, managing director of capital markets for Direxion.

VanEck simultaneously came out with its own fix. On April 13, its indexing arm said it would expand its lineup to larger companies. The change would force the junior ETF to buy some stocks and pare down others.

But those trades won't happen for months because passive funds are obliged to follow the investment strategy outlined in their prospectus. Shareholders must wait for the next scheduled rebalance in June.

With the ETFs paralyzed, traders began bidding up the stocks being added to the index and selling those that the ETF must later shed. Gold prices barely budged the day VanEck announced the change, but stock prices of gold-related companies diverged. Canadian mining company Novagold Resources Inc. dropped 4.7% while Northern Star Resources Ltd., an Australian rival, shot up 6.8%, according to FactSet. The junior ETF, stuck holding the falling stocks, lost 3.5%.

Benjamin Chiu, a quantitative equity trader at BMO Capital Markets, estimates that half of the VanEck Junior Gold Miners ETF would need to be liquidated when the index makes its changes.

Jonathan Tiemann, president of Tiemann Investment Advisors LLC, bought shares of the ETF for clients last year, a bet that could pay off if economic uncertainty sends gold higher. While his view on gold hasn't changed, he is now considering selling those shares.

"It's at a point where the ETF is subject to distortions," said Mr. Tiemann. "It's volatile enough as it is without the risk of some other weirdness happening in the market."

Write to Asjylyn Loder at asjylyn.loder@wsj.com and Chris Dieterich at chris.dieterich@wsj.com

(END) Dow Jones Newswires

April 23, 2017 08:00 ET (12:00 GMT)

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