Beware the Niche ETFs

08/08/2019 10:07 am EST

Focus: ETFS

Landon Whaley

Editor, Gravitational Edge

Exchange trade funds has proliferated well beyond their initial purpose and offer access to every asset class, niche sector, fad and trading strategy, sometimes with dangerous levels of leverage, warns Landon Whaley.

This week’s Headline Risk comes courtesy of the exchange-traded fund (ETF) industry, which has exploded since the very first one, the SPDR S&P 500 ETF Trust (SPY), began trading in January 1993.

The popularity of these vehicles has reached new heights recently because investors are fed up with the mediocre performance of active managers. In the last few years, investors have plowed almost $3 trillion into passive funds while yanking more than $1 trillion from active ones.

Who can blame them? Most active managers have failed to earn decent returns in one of the longest bull markets we’ve ever experienced. Economically, this is one of the U.S.’s lengthiest non-recessionary stretches. If you can’t earn reasonable returns in this type of environment, why should investors continue to pay management fees year after year?

This insatiable appetite for passive investing has encouraged ETF creators to go far beyond merely allowing investors to mirror the returns of the S&P 500. ETFs enable investors to gain exposure to everything from commodities like gold and crude oil to more esoteric strategies like three times the inverse movement of LIBOR. Further evidence of the ETF industry going too far surfaced when the ETF Industry Exposure & Financial Services ETF (TETF) began trading. This ETF is composed of companies that are driving and participating in the growth of the exchange-traded funds industry.

An ETF of ETFs! Are you kidding me?

Doing Too Much

If you need further evidence that the ETF industry is doing way too much, look no further than the ProShares Pet Care ETF (PAWZ).

According to Proshares, “PAWZ is the first ETF that allows investors to capitalize on people’s passion for their pets. PAWZ invests in a range of companies that stand to potentially benefit from the proliferation of pet ownership, and the emerging trends affecting how we care for our pets.”

I’ve developed and traded a ton of macro themes over the years, and I can honestly say it never occurred to me to figure out a way to cash in on the “proliferation of pet ownership.”

While in theory, it is a strong play— representing a strong recent trend, just look at what people are sharing on Facebook; this is a concentrated ETF, holding just 25 companies, and it’s overloaded with retailers and small caps, which are two of the worst places to risk capital during a Winter Fundamental Gravity.

This concentration in markets that get whack-a-moled during Winter is why PAWZ made its trading debut on Nov. 5, 2018, and promptly lost -16.0% of its value before the end of the year. In fairness, it’s crushed it this year with a solid double-digit gain thanks to its exposure to the health care sector. 

It doesn’t matter if you want to ringer the register with pets, cash in on the obesity epidemic with the Janus Obesity ETF (SLIM), or ride the millennial wave with the Global X Millennials Thematic ETF (MILN). No matter your investing interests or approach, only consider investing in ETFs with sector exposure concentrated in favorable sectors for the prevailing Fundamental Gravity.
The reality is that it doesn’t matter if you’re invested in pets, obesity, or millennials, if you trade in opposition to the underlying FG, your portfolio is going to get body bagged.

While some of these niche ETFs may be representing an area of growth, they also tend to be the first things investors will abandon when times get tough.

Bottom Line

Beyond ensuring your ETFs are Fundamental Gravity-compliant, a final word of caution.

Sometime in the not-so-distant future, there will be a market event that wipes out one of these ridiculous ETFs, destroying a lot of personal wealth and causing sweeping reforms across the entire ETF industry in the process.

Anytime there's an instrument that allows Joe Anybody with $100 and a smartphone app to trade the British Pound with four times leverage such as the Citigroup Global Markets Holdings Inc. (UGBP) or biofuels through the Swedish Export Credit Corp. ETF (FUE), it’s not going to end well.

Don’t get me wrong — ETFs are an essential and highly effective tool for investors. But do yourself and your portfolio a favor by keeping it simple. The key to superior risk-adjusted returns is not loading your account with the most leveraged, esoteric ETF you can find. The key is to remain data-dependent, process-driven, risk-conscious, and aligned with the current FG. 

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