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]