When & How To Use Niche ETFs

May 16, 2017

News of a massive worldwide cyberattack involving Windows pushed the PureFunds ISE Cyber Security ETF (HACK) and the First Trust Nasdaq Cybersecurity ETF (CIBR) sharply higher Monday. Both funds, which focus on cybersecurity firms, were on the frontline of action following the latest news.

That’s a great example of what niche investing is all about.

The Wannacrypt ransomware attack late last week caused the appeal of cybersecurity ETFs soar this week. HACK and CIBR rallied some 3% on Monday, putting year-to-date gains at 16% and 13.5%, respectively. 

Chart courtesy of StockCharts.com

HACK and CIBR are considered “niche” funds because of their narrow focus on a specific corner of the market. But the definition of niche can vary from investor to investor.

Niche can be a small segment of the market, as narrow as a subsegment of a specific sector—cybersecurity or robotics as a subsector of technology, for instance. It can also be a thematic area of investment that goes across different sectors.

Another example is a fund like the Global X Millennials Thematic ETF (MILN), which is niche for its underlying theme that connects the companies it owns across various sectors—they all make money off of millennials’ spending habits.

Any way you define it, niche ETFs can be used in different ways.

For some, they are merely tactical, short-term tools to express a view on a pocket of the market. For others, a niche can be a long-term play that takes time to come to fruition—like millennials or, say, solar energy. As such, these ETFs would belong in the strategic bucket of the portfolio. There’s no one way to do it.

We talked to ETF strategist Grant Engelbart, who’s a portfolio manager at CLS Investments, for his road map to using niche effectively. Here’s what he had to say ...

 

Understand The Risks

Adding niche ETFs to a portfolio can help diversify it, working as a risk management tool. Better diversification should mean lower overall portfolio risk.

The flip side is that niche ETFs could also increase the risk of a portfolio if you end up adding too much exposure to single stocks. By design, niche ETFs are concentrated, narrower portfolios, and can carry a lot of weight in a handful of stocks. Any underperformance in one of the top holdings could drag your overall returns.

“If used as, say, adding floating rate securities to manage your interest rate risk in fixed income, these ETFs can help you manage portfolio risk,” Engelbart said. “But you could be adding more idiosyncratic risk to your portfolio, too, if you have ETFs that have 10-20% weighting in a single stock.”

Know Where Niche ETFs Fit Best

The best application of niche ETFs is the one that best suits your investment needs and goals. That said, consider these two broad possible applications. First, it’s harder to argue niche ETFs as strategic allocations rather than tactical.

“Satellite usage makes a ton of sense in niche ETFs,” Engelbart explained. “They’re great to pair with broader exposures.”

For example, you may own emerging market stocks. You may also be bullish on India’s demographics and want added exposure to India’s small-cap and infrastructure stocks. Adding niche ETFs tapping into those segments to your broader emerging markets ETF allocation makes sense, he says. This is one of the common ways CLS incorporates niche to the portfolio.

The same applies to cybersecurity, or robotics—adding narrower exposures to your broader-growth technology ETFs. Niche funds are great tactical overlays, Engelbart notes.

But that’s not the only use. The example of MILN, again, or the Long-Term Care ETF (OLD), shows that niche exposures can also play out in the longer term. Holding on to these funds in your broader equity bucket may make strategic sense.

 

Overlap Is OK

With niche ETFs, you might find you own the same stock twice in your portfolio—once in your broader ETF, the other in a niche fund.

“Overlap is OK. We’re far more concerned with correlation between two products,” said Engelbart. “When we’re choosing a niche ETF, we look for different valuations and low correlations between products. That’s more important than overlap.”

If you get funds that are highly correlated, diversification potential goes down. The idea of niche is to capture performance that’s different from your broader, vanilla ETF.

Value is another important factor in niche investing. “Make sure the securities in your niche ETF aren’t priced out of their normal range” (to the upside), because returns could be limited, he says.

Know Your Niche From A Hot Fad

Finally, there’s the issue of knowing when a niche is a viable investment idea as opposed to a quickly burning fad.

A lot of times, niche ETFs come to market as response to investor demand, but are they simply tapping into the latest “hot thing” that will soon pass. Unfortunately, there’s no easy way to tell one from the other. But you can discern a good investment based on valuations and on as much data as possible on the underlying securities, notes Engelbart.

“You want to make sure you’re buying something that’s trading within its normal price range,” he said. “Bitcoin is a great example—is it a fad? How do you value the underlying?”

“We want to be able to value what we’re buying, and if we can’t, we avoid it even if the ETF is ‘cool,’” Engelbart added. “Pay attention to total risk, to valuations and to index construction.”

You can find several other niche ETFs in our Theme Investing Channel.

Contact Cinthia Murphy at [email protected]

 

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