Have you heard of HACK or CIBR? SLIM or MENU? IPAY or ITEQ? These are just some of the many niche ETFs that have been introduced in the past 2 1/2 years.
They are “thinly constructed” funds that trade more like subsector rather than larger sector funds, says Todd Rosenbluth, director of ETF and Mutual Fund Research at CFRA.
These ETFs tend to follow a theme, hold a limited number of stocks and trade in limited volume. Their assets are often in the tens of millions, much smaller than many other ETFs, and they have expense ratios usually between 60 and 75 basis points, several times higher than the expense ratios of broader sector index ETFs. In addition, their bid-ask spreads can be wide.
Due to their narrow focus, many equal-weight their assets or use some sort of tier weighting system, giving more weight to certain categories of stocks than others in order to avoid having one stock much more heavily weighted than others.
Given these characteristics, do niche ETFs have a place in investors’ portfolios?
“They can do very well if there’s demand for underlying securities, which sometimes work in your favor and sometimes don’t,” says Rosenbluth.
Ben Johnson, director of global ETF Research at Morningstar, is much more critical. “By no means should investors interpret the proliferation [of niche ETFs] as a sign of missing out on something. … That’s not a reason to buy into them now.” But, says Johnson, niche ETFs could be useful under certain circumstances as a substitute for a single stock, though still very risky.
HACK, which invests in software and hardware companies involved in cybersecurity, is among the more popular niche ETFs, with more than $1 billion in assets and trading volume in the hundreds of thousands of shares per day rather than thousands or just hundreds for many other niche ETFs.
As of Friday’s close, HACK was up 12.9% year to date and up 31.2% for the full year, but that’s pretty much in line with the gains of the Nasdaq, which has gained 13% YTD and 29.2% for the year.
SHE, which invests in companies that have more women in management and/or on their boards of directors than other companies, based on research that such companies tend to outperform, is also among the better known thematic ETFs.
It has $314 million in assets but it came to market in 2016 with a $250 million investment from the CALSTRS, the California teachers pension fund, and has daily volume often in the single-digit thousands.
It has also underperformed the S&P 500 year to date — up 5.15% compared with 6.38% — and for the past year, up 14.48% versus 18.5%.
Johnson, Rosenbluth and Dave Nadig, CEO of ETF.com, say SHE is not really a niche ETF because its theme encompasses equities in multiple sectors and because it has institutional support, from endowments and pension funds other than CALSTRS, due to diversity mandates.
SHE is “more in the ESG vein,” said Johnson, noting that it reflects the G, for governance. (ESG stands for environmental, social and governance standards.)
Nadig of ETF.com recommends that advisors interested in niche ETFs know the composition of the fund and why they want to own it, as they would any other investment. “As soon as you start playing a narrow segment you’re speculating.”
He also recommends that advisors interested in smaller niche ETFs like MENU and WSKY, which invest in restaurants and bourbon and whiskey producers and related companies, respectively, use limit orders, not market orders. “Don’t just put in a market order if you’re not in rush to own a smaller less liquid ETF.”
Rosenbluth says advisors should view these funds as complementary to a core portfolio, not as a core holding, with a view on the underlying stocks.
For example, if they invest client funds in the S&P 500, where tech has the largest weighting (22.5% currently), they could also own HACK or CIBR to focus more specifically on cybersecurity software stocks. Neither HACK nor CIBR hold leading tech stocks like Apple, Google (Alphabet) or Microsoft.
Overlap is a key issue advisors should consider before investing funds in niche ETFs.
TETF, a new niche ETF that invests in financial companies involved in the ETF industry — yes, an ETF of ETFs — has only a 21% overlap with XLF, the SPDR ETF that focuses on the financial sector, says Mike Venuto, the chief investment officer of Toroso, which launched TETF last month.
He recommends that advisors know who is constructing the niche ETF they’re interested in and why. “If it’s an ETF on restaurants, the person behind that should be someone who knows restaurants. Those behind HACK should understand cybersecurity. You should know the people behind those decisions. Read the prospectus.”
The growth in thematic ETFs is expected to continue, with many focused on ESG criteria, according to Nadig and Johnson.
But in addition, there will ETFs that appear to be very niche, such as the ForceShares Daily 4X US Market Futures Long Fund (UP), and ForceShares Daily 4X US Market Futures Short Fund (DOWN), filed by Intercontinental Exchange Inc’s (ICE.N) NYSE Arca exchange, which the SEC recently approved for trading. ETF Managers Group, which launched niche ETFs like WSKY and HACK, will distribute ForceShares.
Johnson at Morningstar says that these leveraged ForceShares ETFs are “evidence of product development run amok.”
— Related on ThinkAdvisor:
- Introducing Swell, a New Impact Investing Platform: Portfolio Products
- What’s More Tax-Efficient Than ETFs? Maybe a Tax-Managed Fund
- Aspiration Drops Minimum Investment in ESG Fund to $100: Portfolio Products
- RIAs Now the Biggest Driver of ETF Asset Growth: Broadridge