Thematic ETFs with a highly concentrated focus can face liquidity problems.
One of the most popular exchange-traded funds (ETFs) in 2020 was iShares Global Clean Energy (LSE:INRG), regularly topping the table of the most-bought ETFs on interactive investor. Of course, it wasn’t just interactive investor customers buying. The combined assets under management of both the version available to UK investors (LSE:INRG) and its US-domiciled equivalent surged from just under $800 million (£581 million) at the start of 2020 to almost $11 billion today.
That was accompanied by strong performance. On a one-year basis, the ETF provided a total return of over 130% in sterling terms. That performance has since come off a bit, with year-to-date returns sitting at a loss of around 20%.
The ETF, however, has potentially bigger problems than a reversal in performance, due to its own success. The dramatic surge in the ETF’s assets has potentially created a liquidity problem.
Too big for the index
The ETF tracks the S&P Global Clean Energy Index, which is composed of just 30 stocks. These stocks are also primarily mid and small-cap stocks. Therefore, as the inflows in the ETF have increased, the ETF has come to own increasing amounts of the stock in the index.
As a report by SocGen quoted in the Financial Times points out: “The problem stems from a cocktail of large money flows in the ETFs replicating an index launched 14 year ago, whose rules seem no longer suitable to the large assets collected by the ETFs.”
SocGen continues: “The index rules lead to a relatively high concentration, the selection of some poorly liquid stocks and the overweight of smaller caps at the expense of large caps.”
The bank points out that the ETF owns around 8% of the total market cap of six of the stocks in the index and 6% of a further eight. That means that the ETF has a sizeable position in almost half its constituents.
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This can create all sorts of the problems for the ETF owing to the inflows it has amassed. When the ETF comes to rebalance its portfolio, it will have to sell a relatively large amount of shares of some of the companies in its portfolio. Given that the stocks are relatively small and illiquid this can potentially cause downward pressure on the price of the stocks in question. The ETF could also struggle to sell stocks if it experiences large outflows.
To address liquidity risk and concentration concerns, S&P Dow Jones Indices has unveiled proposals to increase the number of holdings of its clean energy index from 30 to 100.
With this in mind, interactive investor announced earlier this week that it has put iShares Global Clean Energy, part of its ACE 40 list of funds, “under review”. Dzmitry Lipski, head of funds research, at interactive investor, says: “Given the concentrated nature of the S&P Global Clean Energy Index and the mid-small cap focus, the huge inflows heightened the liquidity risks of the underlying 30 stocks.
“While these proposals look sensible, given the proposed changes to the index methodology, we will review how this change will impact the underlying portfolio exposure and whether it will continue to be the best option for investors in the clean energy sector.”
A wider issue
However, this is not an issue impacting just the iShares ETF. Over the past year or so, so-called thematic ETFs have become increasingly popular. Recent data from research firm ETFGI shows that nearly $350 billion was in thematic ETFs at the end of February 2021. This dramatic increase in popularity is creating some concerns about liquidity in other thematic ETFs.
For instance, earlier this year Citi, the global bank, put out a report highlighting liquidity risks. It pointed out that ETFs were responsible for about 25% of the ownership of biotech company Organovo (NASDAQ:ONVO) and medical firm Compugen (NASDAQ:CGEN). This was largely driven by thematic ETFs.
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At the heart of the issue is how thematic ETFs give exposure to the ‘theme’ they are trying to capture. As can be seen with the case of the iShares ETF, providing the ‘purest’ exposure to the theme often means tracking an index composed of a small number of small or mid-cap stocks. This gives the investor a very concentrated exposure to the theme with (usually) very little correlation with the broader market.
Presumably, this is what many investors want from their thematic ETF. Of course, as we can see with the iShares Global Clean Energy ETF, if the popularity of the theme catches on, it can lead to money flooding into a relatively small number of illiquid stocks.
Some thematic ETFs and indices take a slightly wider approach, with a looser interpretation of which stocks are part of the theme. For example, the recently launched L&G Hydrogen Economy ETF (LSE:HTWO), as the name suggests, looks to give exposure to the broader 'hydrogen economy' rather than just pure-play hydrogen energy companies. As a result, it has significant exposure to some large-cap traditional car companies. L&G argues that because these companies are developing hydrogen-related vehicles, they are ultimately part of the wider hydrogen energy economy theme.
However, others have criticised the inclusion of such stocks, arguing that their relation to the theme is tangential and constitutes ‘padding’. But this so-called padding potentially means there are more large-cap and liquid stocks in the portfolio, reducing some of the risks seen by iShares Global Clean Energy.
So, there is potentially a trade-off here. Thematic ETFs can track a basket of thematic ‘pure play’ stocks to give a much more concentrated exposure to the theme, or they can include a wider range of related stock, potentially reducing liquidity risk.
That’s not to say looser-defined thematic ETFs do not also face liquidity risk. To ensure they are not dominated by a handful of large caps and end up looking too much like the wider market, these ETFs, such as the L&G Hydrogen ETF, use an equal-weighting methodology or cap the size of holdings (many of the more concentrated thematic ETFs also do this).
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This increases the portfolio’s bias towards smaller and less liquid stocks. The L&G ETF is still only 28 stocks, so large inflows to the ETF could still create problems – however, the risk is reduced by fewer pure-play stocks in the index.
Ultimately, it is up to both the index providers and ETF issuers to decide how to strike this balance. A more concentrated pure-play focus may work, while an ETF is smaller and a theme not so popular, but as happened with iShares Global Clean Energy, it becomes less tenable as interest picks up and the ETF sees a flood of inflows.
BlackRock and S&P Global Indices have recognised this, hence the current attempt to change the index’s methodology, increasing the number of stocks held. To do so, however, the methodology for inclusion has been loosened. This makes sense and is necessary but, ultimately, means the ETF will soon start to offer a less pure-play and concentrated exposure to the theme.
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