The Trouble With Niche ETFs

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I’m glad to see a big publication pick up the theme because the characterization is largely correct.

Watching some of the sector ETFs that have been rolled out recently has left me wondering who could possibly want to invest in them. The Global X Fishing Industry ETF (NYSEArca:FISN) springs to mind as an example, but there are plenty of others.

The proliferation of these funds isn’t just a harmless side effect of the meteoric rise of ETFs. I fear that they fail to provide many of the benefits of more traditional index ETFs.

To be fair, these niche funds aren’t exactly a new phenomenon—funds that have turned out to be too granular for investors have come and gone in the past. The textbook example is the HealthShares line of 19 ETFs that was shuttered back in 2008. Apparently their Metabolic-Endocrine Disorders ETF wasn’t the hit they’d hoped it would be.

So, given the history, why the push into increasingly narrow market slivers featuring less and less of the diversification touted by ETF issuers?

Probably the best explanation of the situation comes from Rick Ferri, who says in the WSJ piece:“It’s like throwing Jell-O against the wall; some of it sticks.”

ETF issuers may have simply resorted to a process of natural selection to determine what works in the market. The occasional left-field product that scores big—like the Market Vectors Rare Earth/Strategic Metals ETF (NYSEArca:REMX) that has garnered nearly $245 million—may be worth the four or five funds that don’t make it.

As I mentioned in a previous blog, it seems likely that many of the funds on the market today won’t survive for the long haul, simply because over a third of all ETFs have less than $16 million in assets.

That’s not a huge issue because fund closures are relatively painless, but it does hint at the “see what sticks” mentality among ETF companies that Ferri is talking about.

So, the lingering question here is why do some of these products take off?

The answer seems to be that the old stock-picking instinct has come to haunt the index fund world.

The popularity of niche-industry ETFs is largely due to investors looking to outsmart the market by choosing industries they believe will outperform. To my knowledge, there’s no evidence that investors can reliably do this.

And while it’s true that even narrowly defined ETFs offer diversification benefits beyond buying a single stock, they do so to a far lesser extent than normal index funds. Often the vast majority of the weight in niche ETFs is in just 10 names.

So, while the occasional niche ETF may be a big winner for issuers, it seems likely that investors chasing the latest hot industry will for the most part lose out, just as they do when they try to pick individual stocks.

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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 The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: FISN , REMX

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