How to Use Niche ETFs In Your Portfolio

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 a unique value style fund or low volatility strategy with hundreds of underlying holdings spread across multiple sectors. I’m speaking specifically about ETFs that are dedicated to small corners of the investment universe such as restaurants, cancer research, mobile payments, and others.

Many of these unique ETFs have as few as 30 and at most 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. Some debut in the right place or the right time and are able to quickly build a loyal base of investors, while 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 of them have been well thought out by a team of investment experts or product managers and designed to meet the needs of a specific investor group. You wouldn’t believe the time and money it takes to not only launch an ETF, but 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 what steps should be taken to properly analyze their value proposition.

Example 1: Cyber Security Stocks

The most important step in your due diligence process is fully understanding the structure, costs, and liquidity of the ETFs in this space. As an example, the PureFunds ISE Cyber Security ETF (HACK) has 35 underlying holdings in a market cap weighted asset allocation. This ETF charges an expense ratio of 0.75%, has total assets over $1 billion, and daily average trading volume of over 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% 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

Another random example of a niche strategy is the newly released The Restaurant ETF (BITE). This fund is the first of its kind to invest exclusively in an equal weighted portfolio of 45 well-known service and dining companies. BITE also charges an expense ratio of 0.75%.

Now besides the obvious differentiating factor of the unique portfolio, BITE is employing an equal weighted asset allocation methodology. This levels the playing field for each of the underlying holdings and keeps huge companies like Starbucks Inc (SBUX) or McDonalds (MCD) from dominating the fund’s performance.

Because BITE was just released, it’s too soon to know how if this investment will attract steady capital and volume. That should be a cautionary factor that is considered 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 over-reliance on a specific outcome to achieve your investment goals.

I view ETFs like the ones mentioned above and hundreds of others as tactical positions. This means 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 5-7% 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 a tempting value that is ripe for a turnaround.

The Bottom Line

Niche ETFs offer differentiated strategies that may be attractive to those comfortable taking a higher degree of risk and paying a premium in cost above more diversified alternatives. Under favorable circumstances, they can provide a high degree or alpha (or outperformance) as certain industry groups surge. However, these funds should be used in moderation to avoid becoming overly tied to a single strategy or inducing too much volatility in your ETF portfolio.