Boom in niche ETFs

An ETF strategist weighs in about the pros and cons of nontraditional ETFs

Passive investors are enjoying unprecedented power to make tactical plays thanks to the rise and rise of niche ETFs. 

With the potential to outperform their traditional alternatives, albeit with higher risk, these niche products give investors the chance to tilt for tax efficiency, interest rate protection or increased income.

“We use ETFs across all of our models, but specifically in our fixed-income model to target certain credit categories,” says Brent Vandermeer, portfolio manager and executive director at Vandermeer Wealth Management. “In a way, we’re tilting away from the broad index and designing a portfolio with an opinion on rates, currency, credit quality, etc. ETFs allow us to do that in a targeted way without picking a few individual bonds.”

That’s not the end to their advantages, according to Vandermeer. 

“You can get the exact exposure you want, and you can therefore design a very specific portfolio,” he says. “Liquidity is good on ETFs as long as the underlying exposure is liquid as well. We take the problem of reduced availability and liquidity with most bond desks out of the equation. We lower costs when compared to most actively managed mutual funds.”

However, they do have a downside: liquidity and trading risks can sometimes become problems with the more niche ETFs.

“If the sector one is trying to target has liquidity issues already, the bid-ask spread of the ETF will be quite wide and will result in inefficient pricing and cost drag,” Vandermeer says. “One has to be very aware  of the trading characteristics of the underlying holdings, and they can’t just blindly buy a niche sector ETF without considering this issue.”

So what strategies are the most effective for ETF investors?

“Generally, investors should look to build a comprehensive, globally diverse core portfolio out of ETFs and then add satellite positions around that core (actively managed funds, niche ETFs, shares or alternatives) to add alpha,” Vandermeer says. “Then, work with a portfolio manager who rebalances and monitors the portfolio constantly so that they can rest assured that they’re best served riding out the market fluctuations and staying invested over the long run.

“The passive or smart-beta ETF strategy can take away the emotional drama of wondering if the active manager ‘still has the magic touch,’” he continues, “and can therefore improve the behavioural risks to maintaining a portfolio strategy over the long run. That’s key. So costs are lower, transparency is higher, and the likelihood of sticking to the plan is much greater.”