Exchange traded fund providers have crafted a slew of investment strategies, including more specialized and niche offerings. While some of these ETFs may provide an interesting way to focus on a specific sector, investors should not go overboard with their allocations.
Investors should not solely rely on specialized ETFs to construct a diversified investment portfolio. With specialized ETFs, investors may become overexposed to riskier areas of the market in their attempt to chase after returns.
“(Investors) may think they are diversifying because they have what seems like an unusual asset class or sector, but typically we see diversification suffer when investors are using niche ETFs,” CFP professional Peter Lazaroff, portfolio manager at Acropolis Investment Management, reports Sheyna Steiner for Bankrate.
Specialized ETFs have an extremely narrow focus, targeting a certain industry or country.
Additionally, some “will focus on what is called an investment factor by focusing on small-cap stocks, value stocks, or low-volatility stocks, for example,” CFP professional Jonathan Duong, CFA, founder and president of Wealth Engineers, said in the article.
Some studies have shown that value stocks and small-cap stocks typically outperform the market over time, and investors who are interested in these areas can utilize ETFs to gain market exposure. However, Duong warns that these types of strategies may be more volatile, which could cause some to jump ship prematurely. [Specialized ETFs Too Risky?]
“If you move in and out of funds to chase the latest ‘smart beta’ strategy, you are destined to failure. In that case, you would have been better off with a much simpler approach,” Duong added.
Traditionally, investors would stick to some broad market stock positions, funds or ETFs for their so-called core exposure. Specialized ETFs act as so-called satellite holdings supplement their core positions.
“Specialized ETFs may be held long term to fill gaps in a diversified portfolio, or shorter term to speculate or hedge existing positions, oftentimes through leverage or inverse leverage,” Darryl J. Poisson, founder and president of DJP Wealth Management, said in the article. “Specialized ETFs are also appropriate to gain specific and targeted exposure to a particular area of conviction.”
Since retail investors don’t have the deep pockets that institutional traders enjoy, most investors may be better off sticking to plain-vanilla ETFs that track a broad index of hundreds or even thousands of stocks as a way to generate better risk-adjusted returns in a core portfolio position. [Niche and Alternative ETFs Push Up Overall Fees]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.