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Navigating the world of exotic ETFs

It is hard to find an asset class that has seen more explosive growth and diversification in recent years than exchange-traded funds, including a proliferation of exotic products that track highly niche indexes.

“It’s definitely become a more and more complicated process as time goes on, because they’re just so many options in this space,” says Dana D’Auria, director of research at Symmetry Partners, a registered investment advisor based in Glastonbury, Connecticut.

Those options run the gamut from low-cost, plain-vanilla funds that track indexes such as the S&P 500 to far more exotic, niche-focused ETFs that might be entirely concentrated in an individual country, a certain commodity, or a set of companies in a particular sector.

D’Auria is highly cautious about exotic ETFs, warning that “they might be a fit not for an investor but a speculator” and that therefore clients should heed the iron rule of gambling.

“Don't put in any money you don’t want to lose,” she says.

Grant Engelbart, a portfolio manager at CLS Investments, takes a more sanguine approach to exotic ETFs, arguing that they can provide a healthy balance and diversification to a portfolio, offering exposure to niche markets that might have a tremendous upside.

But all things in moderation.

At CLS, a third-party money manager focused on ETFs in Omaha, Nebraska, the firm aims to pair clients with funds based on their risk tolerance.

So Engelbart suggests that clients with the greatest appetite for risk might have on the order of 10% to 15% of their ETF holdings in so-called satellite positions, while leaving the bulk of their assets for more conventional smart-beta and active products.

“I think you scale that down as you decrease your overall risk level,” he says.

For CLS, the measure of a fund always comes back to an analysis of its underlying value and where it is trading. So now, for instance, following the Trump administration’s move to withdraw from the Paris climate accord and roll back Obama-era environmental regulations, there may be an upside in funds that focus on clean energy companies, which have taken a hit.

“We struggle a little to determine whether some of these areas are properly valued,” Engelbart says. “We'll look at things like clean energy, because it is definitely depressed in price.”

Many niche ETFs also can appeal to clients interested in socially conscious investing.

Clean-energy funds would fit that bill, as would a fund focused on companies that promote gender diversity, that fight obesity or promote organic products. These are all real ETFs.

What's more, some advisors identify an intangible benefit for clients, particularly younger ones, in seeing their money being put in service of a cause that they support.

“The visual look of a client seeing certain things in a portfolio is important,” Engelbart says.

“From an advisor standpoint, utilizing some of these areas as a way to show to a younger clientele, I think it keeps them invested, and part of our risk budgeting system is to keep clients invested," he says. “That's how I think that these products can be used [from] a portfolio standpoint.”

This story is part of a 30-30 series on navigating the growing world of choices for client portfolios.

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