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4 Things to Know About Investing in Niche ETFs

Rebecca Lake

Exchange-traded funds are an attractive alternative to traditional mutual funds for investors who prefer a low-cost, tax-efficient method for investing. These funds are generally designed to track a specific index, such as the Standard & Poor 500 index, but a new generation of ETFs feature a narrower focus.

Niche ETFs follow macro trends, honing in on a group of stocks that fall under the umbrella of a single theme or industry. With just over half of U.S. investors planning to add ETFs to their portfolio in 2017, according to BlackRock, niche ETFs have room to grow.

"I think niche ETFs are appealing to investors because they allow the investor to tactically focus in on an industry they have a view on," says John Weninger, president of Vision Wealth Partners in Appleton, Wisconsin. "They may feel they have knowledge or interest about a certain industry, and a niche ETF allows them to invest in a more passive, indexed way without having to pick a particular company."

Before you dive in to niche ETF investing, there are some important considerations to keep in mind.

[See: 7 of the Best ETFs to Own in 2017.]

It can be difficult to gauge long-term performance. Because niche ETFs are relatively new, investors may find themselves taking a leap of faith where performance is concerned, says Anthony Glomski, principal and founder of Los Angeles-based AG Asset Advisory.

"Many of the niche ETFs don't have a track record. While we know past performance doesn't ensure future results, a history allows us to see how close the ETF tracks what it's investing in," Glomski says. "Those with high tracking error can be costly to investors."

He uses the Alerian MLP ETF ( AMLP), which is designed to track the Alerian MLP index as an example.

"In 2016, investors in this basket of stocks would have made 18.74 percent [on their investment], while those investing in the ETF made just 14.84 percent," Glomski says. "Much of this is tax drag, but it makes a huge difference in your outcome."

Nick Foulks, a financial advisor with Drake & Associates in Milwaukee, Wisconsin, says looking at broader economic and social factors can be helpful in determining how a niche is likely to perform.

"Needs will always trump wants over time. Making sure that you understand trends will be key to position yourself long-term," Foulks says. "Think about factors like aging populations, growing technology needs or advancements in the medical field. These are areas where the needs in society are prominent."

The risk level may be higher with niche ETFs. Because niche ETFs are more specialized, you could be exposed to a greater degree of risk compared to more traditional ETF offerings.

"There are definitely additional risks for investors to consider," says David Feldman, president and co-chief investment officer at Palladiem, located in Malvern, Pennsylvania.

"The most obvious of these risks is that niche ETFs tend to be concentrated in a particular market segment. When that segment suffers, the loss tends to be more pronounced than a broad-based ETF," Feldman says.

Another less obvious risk centers on liquidity.

"Certain niche ETFs may involve access to a less liquid set of securities, making the ability for owners to trade when and at the price they want more difficult," Feldman says. "This may be exacerbated in periods of broad market stress."

Feldman advises that niche ETFs aren't for everyone. The nuances of niche investing may be more difficult for some investors to understand and determining whether a niche ETF's returns justify the reason for initially purchasing it can be challenging.

Jay Hatfield, portfolio manager for the InfraCap MLP ETF ( AMZA) and the REIT Preferred ETF ( PFFR), says current yield is also an important factor in measuring risk.

[See: 10 ETFs to Buy for Aggressive Growth.]

"Investors should understand what risk they're taking to generate that yield," Hatfield says. "In the case of AMZA, the risk is primarily oil price risk. With PFFR, the risks are balanced between a modest amount of market risk and some sensitivity to long term interest rates."

Hatfield says that for higher risk asset classes, such as master limited partnerships, investors can have smaller allocations to the asset class to limit volatility in their portfolios.

Be conscious of how niche ETFs may impact diversification. Zeroing in on a single industry or sector in one part of your portfolio can impact the overall balance of your asset allocation and it's important to be mindful of throwing that balance off-kilter.

"Investors who are planning for long-term goals and creating wealth over time may utilize niche ETFs in a core-satellite type of strategy, where they hold broad indexes as the core of their portfolio and have smaller positions in niche ETFs they feel may perform better over time," Weninger says.

Having single stocks as the satellite portion and niche ETFs that correlate to similar industries may represent greater diversification since it's a basket of companies. Weninger warns that this strategy isn't right for every investor, however, and that attempting to time the market is folly.

Don't buy blindly. Choosing a niche ETF requires an additional degree of care to make sure you're targeting the right sectors.

"When you're looking for niche ETFs, it can be wise to look at several different components," Foulks says. "First, make sure that you have a good understanding of the industry you're investing in. Second, look for trends."

As cultural trends evolve, it may become easier to identify emerging niches that are likely to do well.

"If you can spot one, using a niche ETF to invest in that trend rather than a specific company could be a big win," Foulks says.

Tim Clift, chief investment strategist at Envestnet PMC in Boston, also advises investors to do their homework before investing in niche ETFs.

"Look at the underlying companies in the ETF," Clift says. "How many are there? The more stocks there are, the less company-specific risk you'll have. Are the stocks equally weighted or do a few companies represent the lion's share of the exposure? Are the companies relatively new or do they have a history of success? The niche may be great but the companies could be poorly managed.

Clift also says to examine the niche within the context of the company's mission. For some companies, the niche in question may be their primary business but for others, it may be one small piece of their overall strategy. One final piece of the puzzle is to consider the costs, assets and liquidity of a niche ETF.

[See: 6 ETFs That Let You Buy Micro-Cap Stocks.]

"Many of these niche ETFs end up shuttering because they don't gain enough assets or the trend was fleeting," Clift says. "Understanding what you're buying in this niche world is critical."



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