Concerns about market concentration across key equity benchmarks, as the biggest companies get bigger and bigger, has led many investors to seek diversification. Global X Funds, however, is leaning in.
With a new ETF series that works around Regulated Investment Company (RIC) diversification rules under Section 851 of the Internal Revenue Code, the firm is offering a new twist on what owning the market with an ETF can look like.
The new funds, each focusing on one of the most concentrated sectors today and tracking an MSCI benchmark, include:
- Global X PureCapSM MSCI Consumer Discretionary ETF (GXPD)
- Global X PureCapSM MSCI Communication Services ETF (GXPC)
- Global X PureCapSM MSCI Information Technology ETF (GXPT)
- Global X PureCapSM MSCI Consumer Staples ETF (GXPS)
- Global X PureCapSM MSCI Energy ETF (GXPE)
The idea is surprisingly simple, and yet, incredibly innovative.
How It Works
First there’s the regulatory hurdle.
ETFs, as RICs, are by design meant to be diversified. To that end, RIC rules stipulate the following:
- Positions in a single company or single issuer are capped at 25% of a fund’s total assets. (There are some exceptions, such as U.S. government securities, cash and other RICs.)
- Positions representing at least 5% cannot, when combined, represent more than 50% of the fund’s total assets.
Once a quarter, those diversification thresholds are tested to determine regulatory compliance. If one or both of these requirements aren’t met, the RIC (ETF) must rebalance and address the problem within 30 days.
The diversification rule translates into constraints for equity ETFs that ultimately lead funds to “artificially cap” some of their largest holdings, according to Global X Head of Research and Product Development Pedro Palandrani. Artificial caps can equate to performance deviation from true market cap exposure over time.
Next Up: Product Innovation
Global X’s new lineup of ETFs, called the “PureCap” funds, offer equity sector access without constraining position sizing. These ETFs are designed to track freely the largest names — and concentration that may follow — delivering “pure” market beta at the sector level.
To do that, these new ETFs will, around the quarterly asset test, rely on other RICs (ETFs) to meet regulatory requirements as needed.
For example, imagine that, come the quarterly asset test review, Amazon is more than 25% of the consumer discretionary ETF’s total assets. That ETF could then sell some of that position in anticipation of that regulatory review to bring it below the required threshold. It could then buy a 2x leverage Amazon ETF (like AMZZ or AMZU) or a sector diversified ETF like XLY to bring up that overall exposure to Amazon back to its “pure” market cap representation. That trade would then be unwound post-regulatory review, allowing “pure” market capitalization to run again until the next asset test.
The strategy works because RIC rules don’t “look through” to the underlying holdings of other RICs when accounting for diversification. It stops at the ticker level.
In the Amazon example, if the new ETF were to replace some of its Amazon stock with a position in XLY, consider that Amazon currently represents nearly 24% of XLY’s total assets. Replacing some of that single-stock position with an ETF temporarily would allow the strategy to meet true market-cap capture of Amazon in the sector within the regulatory framework.
Potentially Compelling Approach
According to Global X, the approach could be compelling for institutions and investors looking to express sector views in a market where concentration may lead to performance disparity between capped and uncapped exposures.
“By tracking uncapped versions of MSCI USA sector indices, PureCap funds enable more faithful replication of broader market indices, preserving the natural weight distribution that reflects actual market dynamics and investor sentiment,” Palandrani said.
The new ETFs listed on the NYSE on July 23, and will face their first RIC rule asset test at the end of August.
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