Finding your niche

 By Guest Blogger Doug Rowat

As the explosive growth of the ETF industry continues, we’ve seen a predictable development: greater and greater ETF specialization. As The New York Times put it recently, the ETF industry is carving up the stock market “into ever thinner slices for investors eager to find other next big things.”

These niche, ‘thin slice’ ETFs are typically focused on the technology sector (robotics, cybersecurity or artificial intelligence, for example), but this is becoming less so. In Canada, for instance, specialized ETFs focused on the marijuana industry are, of course, currently all the rage. There are now four weed ETFs listed in Canada versus none less than two years ago. The largest, by far, being the Horizons Marijuana Life Sciences ETF (HMMJ).

But HMMJ embodies one of the key dangers of niche ETFs: concentration risk. The top four holdings of HMMJ total a 44% weight, for example. Not exactly broad diversification and, not surprisingly, HMMJ has five times the volatility of the broader Canadian equity market, which is itself risky. It begs the question: if you’re comfortable with this level of risk, why not simply buy the four stocks and save yourself the 0.75% MER?

But not all investors make themselves aware of the risk, thinking instead that the ETF structure itself assures diversification. But specialized, theme-based ETFs are not only expensive but rival single stocks in terms of volatility. Interested in junior gold mining? The top five holdings of the VanEck Vectors Junior Gold Miners ETF (GDXJ) account for almost a 30% weight and the ETF charges 0.54%. Think the skies will soon be filled with drones? The ETFMG Drone Economy Strategy ETF (IFLY) charges 0.75% and you’d better learn all you can about Aerovironment because this company alone has a 12% weight. Believe consumers will abandon Amazon.com and head back to the shopping malls? The Pacer Benchmark Retail Real Estate ETF (RTL) charges 0.60% and just TWO holdings combine for a massive 30% concentration. And the list goes on.

So, just as only holding a few stocks is a dangerous portfolio strategy, so too is only holding a few niche ETFs. SocGen recently highlighted that one in four stocks lose 50% or more during recessions (see chart). If you have only a few specialized ETFs in your portfolio, which typically focus on risky, emerging industries and have heavy weightings to only a few names, you’ll likely experience similar volatility. HMMJ and IFLY, for example, dropped 24% and 19%, respectively, last year and we’re not even in a recessionary environment. ETFs generally provide great diversification, but for theme-based ETFs, this isn’t the case.

Recessions happen and concentrated investment portfolios can be devastated.

Source: SacGen

There’s also the opposite problem with niche ETFs: are they, in fact, targeting the right market areas? In other words, are they providing ENOUGH concentration? We had Coincapital knock on our door a few months ago plugging their blockchain ETF, Coincapital STOXX Blockchain Patents Innovation Index Fund (LDGR). Coincapital uses “a proprietary artificial intelligence (AI) algorithm to identify companies for the fund.” I’ve lost track of how often I’ve heard the term “proprietary” in sales pitches over the 20 years that I’ve been in the investment industry. Such language immediately gives me pause. When something’s proprietary, transparency becomes difficult and attempts at clarification inevitably result in Catch-22 dilemmas. “Proprietary” sales pitches usually end up something like this: it’s the best investment technology because nobody else has it, but we can’t fully explain it because then everybody would have it.

However, our main difficulty with LDGR was simply that we had little confidence that it was offering direct exposure to blockchain technologies. Consider the ETF’s top holdings (below). Is the ETF investing in the niche blockchain space or will its performance be dominated by the much, much broader market forces affecting the US and Canadian financial and retailing sectors?

Decide for yourself:

Coincapital STOXX Blockchain Patents Innovation Index Fund top holdings

Source: Bloomberg

Overall, it’s not that these specialized ETFs are engaging in false advertising—after all, I discovered all this information because of what they disclose publicly—but problems occur when investors don’t take the time to research exactly what it is that they’re buying.

In other words, if you’re thinking of purchasing a niche ETF, pop the latch and check under the hood.

—————-

Finally, I’ve written many times on this blog that rising interest rates don’t negatively impact Canadian real estate investment trusts (REITs). Here’s an example (https://www.greaterfool.ca/?s=no+vacancy). Yet, what should come blasting across my smartphone to start 2019? Another misleading headline regarding REITs and interest rates:

The Globe & Mail gets it wrong. REITs do great in rising rate environments

Source: The Globe and Mail

Strong REIT performance during periods of rising interest rates shouldn’t be a “surprise”; REITs perform well in these environments. And last year was proof of that. There were four rate increases from the US Federal Reserve and three from the Bank of Canada, but Canadian REITs advanced 4.9% in 2018 (including dividends) versus the MSCI World Index (global equities) which fell 8.2% on the same basis. And, as a long-term investment, REITs have returned 10.2% annually over the past 15 years.

Just add ‘em to your portfolio already.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.