GameStop, ETFs, and Parabolic Moves

I am sure by this point many are aware of the recent surge in GameStop and the attention it has been getting across the media.  The purpose of this article is not to elaborate on the reasons as to why GameStop is surging, nor make any suggestions as to what will happen in the future, but rather to highlight a point that has seemingly gone unnoticed.

How ETFs are Weighted

Technology has changed every industry to the point of being virtually unrecognizable from what it was before. The financial services industry, from a technological standpoint, is no different.  Today, we have access to almost any asset class imaginable through the use of Exchange-Traded-Funds (ETFs). 

Now, if you are unfamiliar with what an ETF is exactly, we can use SPY to help illustrate.  An ETF, like SPY, would be like buying up every S&P 500 stock to its S&P 500 weighting, slicing it up into pieces, and then selling those pieces as a security.  In other words, SPY is basically a stock that reflects the movements of the S&P 500 index. Its pricing is driven by the fluctuations of the underlying securities, in this case the S&P 500 stocks.

There is an ETF out there for almost any asset class imaginable: equities, commodities, bonds, currencies, even inverse funds that move opposite the markets.  Exchange-Traded-Funds can be weighted in two primary ways: either it mirrors its underlying index, which in most cases are weighted by market capitalization, or an ETF can give a relatively balanced allocation to each underlying security it the fund.  As an example, an ETF composed of 100 “homebuilder-related” stocks would allocate roughly 1% to each security.  At the end of each quarter, the ETF gets rebalanced. 

GameStop’s potential impact on ETFs and Portfolios

GameStop has provided an accelerated, exaggerated, yet very real-world case that highlights a problem many investors may not be aware of when it comes to some ETFs.  Because many ETFs are rebalanced quarterly, they have the potential to become out of balance and not be corrected for a period of time. This doesn’t happen very often, but GameStop’s parabolic advance has caused it to occur in some funds.

Let’s look at a Retail ETF as an example.  Our team at Canterbury Investment Management identified a particular Retail ETF composed of a combination of large cap, mid cap, and small cap retail stocks.  To begin the year, this fund’s allocation was relatively equal weighted among 94 stocks.  So, although Amazon is the largest stock in market cap, it had a similar allocation to the other 93 stocks that make up this fund. 

At the end of each quarter, if one stock grows to become a larger portion of the fund, for example, a stock starts out at 1% and grows to represent 2%, it would be rebalanced at the end of the quarter back to a 1% allocation.  GameStop has poked a Grand Canyon sized hole in this method. 

At the beginning of the new year, GameStop represented 1.4% of a Retail ETF.  A meteoric, parabolic rise caused GameStop to take over the entire fund and grow to represent 20% of the fund over the course of 17 trading days.  None of the other 93 stocks in the ETF make up more than 2%, and this anomaly will not be corrected until the fund rebalances at the end of March.

This presents a significant problem to the ETF when it comes to compounding.  Here is why:

The table above shows GameStop’s weighting in the Retail ETF over the course of January, along with its returns, the returns of the other 93 stocks, and the return of the Retail ETF.  At the start of the year GameStop made up 1.4% of the Fund.  Over the next 12 trading days, it more than doubled in value, however because it was smaller in allocation, its impact was not nearly as strong as the other 93 stocks.  Then, as GameStop continued to grow exponentially over the last week, you can see its weight in the ETF begin to grow substantially.  On January 27th, while the other 93 stocks were collectively down -1%, GameStop was up 134%.  Because it had grown to be such a large position in the ETF, the Retail fund was up +12%. 

This poses a significant problem moving forward.  Make no doubt about it, GameStop is a classic bubble, accelerated over the course of a few days.  Its price is being driven up at an unsustainable rate and it will have an eventual burst.  It took 12 days for GameStop to more than double in price, but its impact was almost negligible on the Retail ETF.  Over the next few days, it grew to be 10% of the ETF, and then doubled in value again to be 20% of the industry fund.  When this GameStop bubble bursts, it will have a much larger impact on the ETF than it did when it was increasing in price.  Case and Point: January 28th, GameStop fell by -44%.  The other 93 stocks were only down -1.59%, yet the Retail ETF was down -9%. 

Bottom Line

Our purpose here is not discourage ETFs, in fact our firm believes strongly in the use of ETFs.  Exchange-Traded-Funds are some of the most useful and powerful investment tools ever created, but it is important for investors to be aware of some of the risks they may unknowingly expose themselves to in investing.  GameStop has put some ETFs out of balance, but even ETFs that are weighted by market cap have similar risks.  For example, collectively, Tesla and Amazon make up 40% of the Discretionary sector.  As those two stocks go, the rest of the sector goes.

The same sort of analogy applies to portfolio management.  The S&P 500 is not an efficient portfolio and can get out of balance.  Today, technology-related stocks make up 40% of the S&P 500 and have had a parabolic rise over the last year.  Now, these stocks in technology are by no means the dinosaur that GameStop is as a company, but all security prices are based on Supply & Demand and therefore will all experience both bull and bear markets, regardless of the underlying company’s success.

 

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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