Niche ETFs Are Hot, But Do They Have Longer-Lasting Potential?

Niche ETFs Are Hot, But Do They Have Longer-Lasting Potential?

Wouldn’t it be nice if you could snap your fingers and right before your eyes appears the ETF that invests in the exact hot new theme or technology you were looking for and provides exposure to, say, names like PayPal ( PYPL ) or even Bitcoin ?

[ibd-display-video id=2411914 width=50 float=left autostart=true] Well, this is possible today, thanks to the proliferation of niche ETFs that track anything from cryptocurrencies and social media stocks to politically driven themes in the corporate sector.

If you’re a huge social media fan and are searching for such an ETF, $167.7 million Global X Social Media ( SOCL ) will do the trick. Thinking of capitalizing on the newest developments in the robotics and artificial intelligence ( AI ) arena but don’t know where to start? Look no further: $1.7 billion Robo Global Robotics & Automation Index ( ROBO ) and $1.1 billion Global X Robotics & Artificial Intelligence ( BOTZ ) are there to serve your needs.

Believe that electronic payments are the way of the future? $207.1 million ETFMG Prime Mobile Payments (IPAY) will show you the way. Would you like to capitalize on the recent wave of data breach? $1.1 billion ETFMG Prime Cyber Security (HACK) gives you exposure to firms that are there to fix the mess. The list goes on.

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What do all these ETFs have in common? They’re all focused on a theme or a subsegment of a growth industry; they’re up between 14% and 61% through Nov. 6; and many feature company names you’ve never heard of.

But as appealing as all this sounds, are these funds outperforming just because they’re trendy, or do they have longer-lasting potential?

“Increasingly, investors have been adopting certain thematic ETFs to gain exposure to trends that they think have growth prospects to round out their portfolios,” said Todd Rosenbluth, CFRA’s Director of ETF & Mutual Fund Research. “As opposed to buying individual stocks that offer exposure to some of these trends, these thematic ETFs offer the benefits of diversification, which can be particularly important because stocks don’t all go up just because they’re in a certain industry.”

He believes there is a hot-money theme to this: “Money tends to, wrongfully, chase performance in the investment world … . The trend is your friend until it’s not.” It’s impossible to forecast when a theme will stop being a positive for the stock market, he notes, “but when that happens, I don’t think the money will be as sticky.”

That said, ETF.com CEO Dave Nadig points out that thematic ETFs often fill a particular need. “The traditional classification systems are often really laggy: It takes a long time for any company classifications to catch on,” Nadig said. “The thematic ETFs are a way of grabbing stocks that exist across a couple of different subindustries and grouping them together in a way that’s investable.”

Nadig also says thematic ETFs allow speculative investors to react to headlines really fast, whether going long or short on these funds. “What they really are replacing is not traditional sector investing, they’re replacing single stock selection,” he added.

The funds also provide access to global names that individual investors may not know of or can’t easily trade. For example, SOCL’s top holdings include social media giants such as Tencent (TCEHY), China’s largest internet service and social network provider, Facebook (FB) and Twitter ( TWTR ). But the fund also holds lesser-known names such as Mail.ru, a social networking and communications portal for Russian speakers worldwide, and Mixi, a Japanese social networking service.

Typically, niche ETFs hold between 30 and 80 stocks, resulting in a rather concentrated portfolio as many of these stocks share quite a few similarities, points out Nadig. This can make them more risky vehicles to own.

He believes that over time, “more of these funds will get brought to market … with more institutional support, by larger, more well-known ETF issuers – and those will stick around for quite some time.”

On the other side of the equation are thematic fund and index issuers themselves.

“We don’t think it’s a fad. We think this is actually a natural evolution of how classical sectors are changing, and we’re trying to remain at the forefront of it,” said Kris Monaco, managing partner at Level ETF Ventures and co-founder of Prime Indexes, the indexing company behind several ETFMG ETFs.

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Earlier this summer, ETF Managers Group, advisor on 13 PureFunds ETFs, took over as the funds’ sponsor, rebranding the entire family with the ETFMG name and changing the index on three funds to Prime Indexes. Funds in the family include HACK, IPAY and other niche ETFs. A 14th fund, AI Powered Equity (AIEQ), was launched last month by ETFMG and EquBot.

For funds such as HACK, “I think certain thematic ETFs are very popular partly because the general investing population realizes things like cyber security are in demand and only going to increase as the amount of cybercrime across the globe continues to increase,” said Chris Yeagley, managing partner at Level ETF Ventures and co-founder of Prime Indexes. “But I don’t think those investors generally know who are the companies that are fighting the war against cybercrime.” HACK gives them exposure to a basket of firms involved in this area.

Because of their niche focus, thematic ETFs tend to charge higher fees. The above funds all carry expense ratios between 0.60% and 0.95%. But competition has been pushing some of the fees down, and experts believe this trend will continue.

To help manage risk, investors need to understand what kind of index those ETFs follow, what securities they hold and whether they track the index closely or not, Rosenbluth points out. Two similar-sounding ETFs may have the same fees, but different performance, he notes.

Fund size and liquidity are also important factors. Funds with less than $50 million in assets “are more likely to close than other products,” he said. “I think equally important is looking at the trading volume of the ETF in relation to the trade you’re looking to make.”

ETFs that don’t trade as much or don’t have as much in assets tend to have a high trading cost due to the wider bid-ask spread, he adds.

In general, investors should still consider the same factors with a niche fund as with any other ETF, such as fees, tradability and how closely it tracks the underlying index, industry experts say.

“The way you approach a niche ETF should be the same way you approach any ETF – but on steroids,” said Nadig. “You still have to ask those questions with a niche ETF, but they matter even more.”

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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