Not all Niches are Worth Filling

Just because there has been a proliferation in niche ETFs, doesn’t mean that you should buy into them

Hortense Bioy, CFA 11 December, 2012 | 11:58AM
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The number of niche exchange-traded funds (ETFs) has mushroomed over the last few years. This seemingly endless trend has been due not only to the growing and ever-evolving investor demand for ETFs, but also as a result of the increasingly competitive nature of the global ETF market.

The race for market share has pushed ETF providers to develop products that offer exposure to ever-thinner slices of the investable universe.  In some cases, this has led to genuinely useful innovations that could benefit investors. In others, we have seen instances where products’ complexity has ensnared those who have failed to do proper due diligence.

The Problem with Niche ETFs

When talking about niche products, sector equity ETFs are often the first example that springs to peoples’ minds. In recent years, we’ve seen a multitude of ETFs emerge that give investors access to some extremely narrow sub-sectors. This is especially the case in the US. These ETFs range from smartphone, cloud computing and social media ETFs to fertiliser ETFs. No doubt that some investors see these types of funds as useful tools to express a view on very particular segments of the market. But the vast majority are overly specialised, too thinly traded, and ultimately not worth considering.

The vast majority [of these niche equity ETFs] are overly specialised, too thinly traded, and ultimately not worth considering

The main problem with niche ETFs like these is their limited diversification benefits. The narrower the underlying exposures, the less diversification benefits they offer for long-term investors. In fact, the great majority of niche ETFs are suitable only for investors looking to overweight certain areas of the market within a broader, diversified portfolio. They may be useful for tactical asset allocation purposes but they are generally not meant to be used as a core portfolio building block.

Having said that, not all sub-sector ETFs are as arcane as those mentioned above; funds focused on alternative energy, water and social responsibility have the potential to appeal to a broader range of investors. Cases in point:  the iShares S&P Global Clean Energy ETF (INRG) has attracted roughly €80 million in assets so far, while the iShares S&P Global Water ETF (IH20) has about €150 million in assets under management (AUM). These “thematic” funds, however, don’t come cheap relative to more broadly focused ETFs. Total expense ratios (TERs) for both these funds are at the 0.65% mark. On top of that higher price tag, these ETFs haven’t necessarily delivered superior performance relative to broader benchmarks.

ETFs Help You Invest in Specific Countries

ETFs also offer geographically focused exposure. Today, it seems as though one can invest in virtually every single country on the planet via an ETF. Take emerging markets for instance. Once considered to be niche, emerging markets have become so mainstream that some providers have chosen to slice the segment ever more thinly. European fund providers offer a range of ETFs that track an array of single emerging market countries ranging from Brazil, China and Taiwan to Turkey and Korea. Recently, db X-trackers launched Europe’s first single country ETFs offering access to Pakistan and Bangladesh.

For those who want to add a bit of spice to their portfolio and believe that a specific emerging country will outperform in the near future, single country emerging market ETFs can be useful, although investors shouldn’t overdo it. They should also be aware that by investing in these markets, they are exposing themselves to high levels of volatility and idiosyncratic risk.

Lack of Liquidity

Another word of caution: niche ETFs tend not to enjoy the same level of liquidity as broad index ETFs. This is because they normally track stocks that are less heavily-traded, resulting in wider bid-ask spreads. This, in turn, can lead to higher trading costs, which is in addition to the higher management fees typically charged by niche ETFs.

Leveraged and Inverse ETFs

Other ETFs that qualify as niche products are those focused on more complex and risky strategies, such as leveraged and inverse ETFs. The skills needed to understand the mechanics of these products make them more appropriate for nimble traders instead of buy-and-hold investors. Many investors who have failed to fully grasp the effect of daily rebalancing on these funds’ returns have had adverse experiences with these products in the past. But despite this, leveraged and inverse ETFs remain popular among a certain class of investors who use them as tools for hedging and speculation.

Niche Bond ETFs

ETF providers have also been busy slicing and dicing the bond space in order to give investors access to more targeted and niche fixed-income offerings.  This allows investors to develop more customised fixed income allocations that mix geographical, risk and sector profiles.

For example, emerging market debt exposure now comes in several different flavours: corporate, high yield as well as local currency. Also, in addition to maturity- and credit quality- segmented bond ETFs, iShares recently introduced the very first sector bonds ETFs in the US. These funds cover the financial, industrial and utilities sectors. Investors who are concerned about the financial sector can now buy the industrial and the utilities funds to create a diversified corporate bond portfolio without any financial exposure.

In summary, some innovations in the ETF space are useful and allow investors to implement more precise strategies. However, not all these innovations are necessarily good, especially when they come in the form of exceedingly complex and risky products.

The original version of this article was featured in Investment Week in August 2012.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Hortense Bioy, CFA

Hortense Bioy, CFA  is global head of sustainability research at Morningstar