The witching hour is fast approaching for many small gold miners.
- Total funds into VanEck gold ETFs have almost trebled to $US14.2 billion since January 2016, while gold prices remained flat
- Small cap fund is now near the compulsory takeover threshold for a number of gold miners
- Rebalancing is likely to cause outsized price movements and volatility in many small gold stocks
Every quarter, mysterious forces are marshalled by the giant exchange traded funds (ETFs) that could mean extremely large swings in value, depending on whether a miner is included, deleted or diluted as the funds are rebalanced.
The popularity of these index-hugging ETFs has grown at an extraordinary pace in recent years, particularly in the gold sector, and, while they are said to be passive investors, they wield extraordinary market moving power.
New York-based asset manager VanEck, which has around $US40 billion ($54 billion) worth of funds under management, dominates the gold ETF market with two funds, GDX for larger cap stocks and GDXJ for smaller caps.
Since the start of 2016, funds under management in the GDXJ fund have risen by 225 per cent, or nearly $US3 billion, while funds in the larger cap GDX have grown by 140 per cent, or $US6 billion.
While the gold price rallied at the start of the period, its stodgy performance over the past year makes the explosion of interest in gold ETFs even more remarkable and they now own more than 7 per cent of Australia’s listed gold miners.
ETFs near the takeover threshold in several gold miners
It is this aggressive growth of the passive funds that is causing problems, as the small cap fund is now pushing up towards a 20 per cent holding in a number of miners, having sucked up stock in line with the index, oblivious to other material matters.
Takeover laws prevent VanEck from moving above 20 per cent, unless of course it went hostile and moved to launch a bid for complete control.
It is something VanEck’s investment mandate prevents it from doing, even if it wanted to.
So the alternative is to dilute or reduce its holdings in stocks near the takeover threshold, and that is where this quarter’s very tricky process of rebalancing comes in.
The magic day is June 16. In theory, at the close of business the two indices will have their new composition completed, which will be announced to the market.
But, for a few weeks before then, a lot of the hocus-pocus, unseen by the broader market, comes into play as new positions are formulated and taken.
A study by the Canadian, resources-focussed investment bank RBC has found there is potential divergence of up to 20 per cent between additions and deletions over a two week period and a 30 per cent spike in volatility on the day of rebalancing.
Some of the GDXJ’s larger holdings of Australian-listed gold miners include Regis Resources and Saracen, both at 19 per cent, while it holds around 14 per cent of Resolute.
Like most of the smaller gold miners, trading in their shares tends to be fairly illiquid and shifting a significant block of shares tends to cause outsized price movements.
While they are unlikely to be deleted from the fund, they would most likely be affected by dilution as the ETF capitalisation threshold is lifted to allow bigger companies in.
Double-edged sword for small miners and investors
The rule changes announced by Van Eck last month will see the size of companies included in the small cap fund increased to around $US3 billion, double the pervious threshold.
Already, hedge funds have moved in looking to make some easy money.
Short positions in Saracen have doubled recently, while shorting has also noticeably increased in the likes of Resolute – up 60 per cent – and Regis.
On the flip side is a company such as Northern Territory-based miner Northern Star, with its $2.8 billion capitalisation, which may now be included in both funds, which would see VanEck needing to accumulate more stock.
And that is the problem with the “value-agnostic” approach of the ETF strategy.
Shares can surge on inclusion and dive on dilution or exclusion, while fundamentally the company has not changed.
“While funds flow in, active investors are competing against passive buying requirements, driving prices higher,” RBC’s Paul Hissey said.
“While on the downside there can often be a lack of support as investors flee the space while mandatory selling continues unchecked from what are essentially value-agnostic investment products.”
In recent months, the tide has turned and funds have started flowing back out of both Van Eck gold ETFs, driven by a combination of factors.
The gold price slipped as French voters installed the moderate Emmanuel Macron into the Elysee Palace, while the expectation of interest rates rising in the US has also hit the precious metal.
However, RBC’s view is that uncertainty over the rebalancing has contributed as well.
Essentially ETFs’ passive and value-agnostic investing is a double-edged sword for many companies and investors, according to Mr Hissey.
“It is great on the way up where performance is often overdone, but painful on the way down,” he said.
“Given the high ETF ownership stake, should money continue to flow out of ETFs as it has of late, companies with a higher portion of VanEck ownership will be the most exposed.”
The way down can be very sharp, with investors reluctant to step and catch a falling knife in what are small, illiquid often not well understood companies.