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Unlike traditional broad-based ETFs, micro-niche ETFs are based on specific sectors.

Since Canadian equities markets are highly concentrated in three sectors—materials, energy and financial services—micro-niche ETFs let investors tap into sectors or asset classes to which they’d otherwise have limited access.

These specialized funds—from the First Trust ISE Cloud Computing Index Fund (SKYY) to the Claymore S&P Global Water ETF (CWW)—are quickly gaining investors’ attention.

Frank J. Restorick, an investment advisor at Raymond James, says micro-niche ETFs that offer access to alternative asset classes with low correlation to traditional stock and bonds can be an effective portfolio diversifier. (These asset classes include real estate, healthcare, agriculture and commodities.)

Micro-niche ETFs that hold stocks, meanwhile, will likely have similar correlation to the equities market. However, they can give the portfolio a tilt in order to harvest higher returns—at higher risk.

Tom Bradley, president of Steadyhand Investments, agrees micro-niche ETFs can be effective portfolio diversifiers, but takes issue with investors who overlook the valuation of such funds.

“The value [any investment] adds to the portfolio has to go beyond diversification,” he says. “People get carried away, whether it’s top-down trends or industry trends. ETFs [make it] easy to access [those trends] but when you move a level up from buying individual securities, sometimes investors forget about valuations.”

Kathy Clough, portfolio manager at PWL Capital, steers away from using micro-niche ETFs in client portfolios. For her, the higher risk they bring isn’t worth it, particularly when broad-based ETFs with a range of market cap companies can provide the diversification she seeks.

“We add our tilts in the risk elements that have shown to provide compensation over the long term,” she says. “We’ll put tilts on with smaller-cap and/or value companies that have been shown to compensate for the extra risk.”

The higher risks associated with niche ETFs means Restorick limits their allocation to 2%-to-3% of the overall portfolio. If the fund offers portfolio diversification, he’ll raise the limit.

“With a 50% weight in equities, you [can] put 5% or 10% of that in two theme strategies as a tilt or overweight,” he explains. “If [that theme is] commodities, you may go a little higher if you’re using it for a diversification tool.”

With ETFs invested in nascent markets with few issuers, getting good investments can be challenging. A few holdings may represent a large proportion of the fund, leading to concentration risk.

Micro-niche ETFs that offer access to alternative asset classes with low correlation to traditional stock and bonds can be an effective portfolio Niche ETFs diversifier.

And, in a small market, the ETF may not be a pure play. The fund’s holdings may be diluted with securities from related industries rather than fully and directly invested in a specific sector. Restorick doesn’t believe this taints the ETF—it’s just the nature of being in a narrow market still in its infancy, he says. Still, investors should know the underlying investments.

Further, narrow sectors often mean fewer investors in the market, so some niche ETFs will be less liquid, and the spread between the bid and ask prices will likely be wider, says Restorick.

While traditional investments typically have long track records, most micro-niche ETFs have existed for only a few years. So advisors should look at the valuations of the top five-to-10 holdings to get a sense of the return and risk projections. “The right client [must be] sophisticated enough to understand the risk, as well as have a large enough account and the time horizon to take on that risk,” says Restorick.

Rayann Huang is a Toronto-based financial writer.

Originally published in Advisor's Edge Report

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