Be very careful with the latest ‘niche’ investments

Much like niche restaurants that come and go, niche investments come into and out of favor, as well. Just as everyone had to be the first to try out that new donut or cupcake shop on the corner, the new craze to hit the investment world is the narrowly-focused exchange-traded fund.

ETFs are designed to track the performance of a diversified mix of stocks, like the S&P 500, but unlike mutual funds, they trade on an exchange and can be bought or sold throughout the day.

The idea behind niche ETF investments is that, unlike more traditional index ETFs, these niche funds track a basket of stocks that are aimed at a single industry or theme.

A couple of prominent examples include the Whiskey & Spirits ETF, which trades under the ticker symbol WSKY, or the PureFunds Video Game Tech ETF (GAMR). Other ETFs that have debuted recently include the SPDR SSGA Gender Diversity Index ETF (SHE), the Global X Social Media Index ETF (SOCL) and the 3D Printing ETF (PRNT).

These investments have garnered a lot of interest from investors lately — more than 2,000 of them have been launched in the past 10 years or so, because they are easy to relate to and understand. If you like to drink whiskey, for example, you might want to find a way to invest in the industry.

If used properly, ETFs can help diversify a portfolio, and these investments are likely much more diverse than investing in a single company’s stock. ETFs can also offer other advantages over their mutual fund counterparts, such as cost and tax efficiency.

But a word of caution: While these niche ETFs can add some interesting spice to your portfolio, they should not be one of the largest ingredients in your mix.

There are a few key reasons for this:

By their very nature, these investments aren’t diverse. That means that if there is a shock to the market that affects that industry, it will have a drastic effect on the value of the ETF. That’s certainly part of the reason that some 16 percent of niche ETFs have failed or closed up shop, including ones that focused on sectors such as wound care, fishing and — niche of all niches — a fund that invested only in companies headquartered in Oklahoma. We tell clients that if they are going to own a niche ETF, they should limit their exposure.

Sometimes the technology an ETF focuses on is priceless, but the companies supplying them aren’t winners. Rather, it’s the users of the technology that make or break its success.

This is where we can learn a lesson from recent history. Think back a few years to the spectacular rise and fall of companies such as WorldCom and AOL. While the value of these companies soared when the internet became mainstream, they ultimately didn’t win out among companies such as Google and Facebook, which built their business on the communications backbone WorldCom and AOL built for them.

This same lesson could be true with companies in the emerging 3D-printing business. The printing companies themselves may not be the key to a profitable investment as much as, say, how a company such as General Electric is using them to design, test and print parts for its jet engines and power plants.

Sometimes the niche offering you’re interested in is actually part of a much larger company. Take the example of The Cybersecurity ETF (HACK), which owns Cisco Systems as part of its fund. But for Cisco, which develops, manufactures and sells networking hardware, telecommunications equipment and other high-technology services and products, cybersecurity is only a portion of its revenue and business. That means your investment might not track exactly with your expectations of how the industry is doing.

The point is that smart investors look to diversify their portfolios at every opportunity. While niche ETFs can certainly play a role in that strategy, it’s wise to move cautiously and with as much information about the investment as possible. After all, if doughnuts and cupcakes can go out of favor, so can your favorite ETF.