As I peruse the list of over 1,800 exchange-traded products, I am struck by how many new funds are dedicated to niche strategies.
Now, I’m not talking about an idiomatic value-style fund or low-volatility strategy with hundreds of underlying holdings spread across multiple sectors. I’m speaking specifically about ETFs dedicated to the margins of the investment universe, such as restaurants, cancer research, mobile payments and others.
Many of these specialized ETFs have as few as 30 stocks and as many as 75 stocks in a specific industry group. They often charge much higher fees than their broad-market peers, and can be struck by transient spikes of volume and asset flows.
The luck of the draw allows some to debut in the right place at the right time and quickly establish a loyal investor base. Conversely, others languish in obscurity until they are virtually forgotten or shut down.
I’m not here to pass judgment on any of these funds — most have been well-thought-out by a team of professionals and were designed with specific needs in mind. You wouldn’t believe the time and money it takes to not only launch an ETF, but to run it on a monthly basis … whether investors show up or not.
My goal is to impart wisdom in how to use these funds within your ETF portfolio and to articulate the proper steps to analyze each ETFs value proposition.
Example 1: Cybersecurity Stocks
The most important step in your due diligence process is fully understanding the structure, costs and liquidity of the exchange-traded funds in the cybersecurity space.
For instance, the PureFunds ISE Cyber Security ETF (HACK) has 35 underlying holdings in a market-cap weighted asset allocation. HACK charges an expense ratio of 0.75%, has total assets over $1 billion and daily average trading volume exceeding 500,000 shares.
Key points to note in the HACK analysis is that certain larger companies are going to have greater influence on the performance of the fund over time. In addition, this ETF has a solid base of invested capital alongside very regular daily trading volume (i.e. liquidity).
It’s also important to note that the expense ratio of this ETF at 0.75% ($75 per every $10,000 invested annually) is on the high side when compared to a broad-based growth ETF. However, the unique tactical approach of a select industry group likely warrants a premium in underlying costs.
Example 2: Restaurant Stocks
The Restaurant ETF (BITE) is a newly released fund, and the first of its kind to invest exclusively in an equal-weighted portfolio of 45 well-known service and dining companies. Like the HACK ETF, BITE charges an expense ratio of 0.75%.
Now besides the obvious differentiating factor of the unique portfolio, BITE employs an equal-weighted asset allocation methodology. This levels the playing field for each of the underlying holdings and keeps huge companies like Starbucks (SBUX) or McDonalds (MCD) from dominating the fund’s performance.
But here’s the caveat: Because BITE is fresh on the market, it’s too soon to know whether it can attract steady capital and maintain high volume. That should be a cautionary factor to consider when adopting a new fund like this in your portfolio.
How to Integrate These ETFs in Your Portfolio
Let’s cut to the chase. Unless you are on the fringe, you probably aren’t going to invest 50% of your IRA in an industry-level or esoteric ETF strategy.
An approach like that would induce high-sector concentration, greater volatility and an overreliance on a specific outcome to achieve your investment goals.
My view on the aforementioned exchange-traded funds (and hundreds of others like them) are as tactical positions.
This means that they will likely have a much lower overall allocation than a core position that has greater diversification and is built to be held long-term. Tactical positions should each represent no more than 5% to 7% of the asset allocation in your portfolio.
In addition, tactical positions are often ones that you can have a more flexible trading approach with. This means you may decide to invest in them over shorter time frames in order to capture a specific trend that is showing momentum, or to get in on a tempting value ripe for a turnaround.
The Bottom Line on Niche ETFs
Niche ETFs offer differentiated strategies that may be attractive to those comfortable taking a higher degree of risk and paying a premium to more diversified alternatives.
Under favorable circumstances, niche funds can provide a high degree of alpha (or outperformance) as certain industry groups surge.
With that said, funds like HACK and BITE should be used in moderation, lest you run the risk of becoming overly tied to a single strategy or inducing too much volatility in your ETF portfolio.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. Learn More: Why I love ETFs, And You Should Too.