ETF Strategist

Are these ETFs cutting-edge or just plain crazy?

Prehistoric investors who put all their shiny pebbles into the then-dominant club industry lost out once spear-and-arrow technologies came to market.

Clearly, diversification into new areas can be beneficial.

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So what are some modern-day investments you might want to trade pebbles for? We asked Morningstar fund analyst Robert Goldsborough, president Matt Hougan, Zacks Investment Research director of ETF research Neena Mishra, and S&P Capital IQ director of ETF and mutual fund research Todd Rosenbluth for their thoughts on some of the quirkier ETFs newly available.

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Which will prove to be winners (like that perennial value investment, fire) or losers (like the short-lived porcupine hat industry)?

Wanna cyber?

Factor Advisor launched the PureFunds ISE Cyber Security ETF (HACK) on Nov. 12. It costs .75 percent and has $58 million under management. It's the only ETF currently focused on cybersecurity.

"The need for cybersecurity solutions will continue to rise as we adopt newer technologies, such as cloud computing," Mishra said. "HACK is a convenient way of gaining exposure to a diversified group of companies from this industry. I believe this ETF will become quite popular."

Goldsborough wasn't so sure. "I'm skeptical of narrow tech ETFs," he said. "Cybersecurity is a big issue, but the price is high, and I'm not sure it offers anything beyond more broad-based tech ETFs."

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Hougan was surprised by the fund's success drawing assets. "Clearly, there was pent-up and prearranged demand for this exposure," he said. "I can't imagine HACK being an integral part of an asset allocation portfolio, but as a niche product, it gets its job done."

Made in China

The Global X GF China Bond ETF (CHNB) opened Nov. 18, with .5 percent expenses and currently holds $48 million. It tracks an index of bonds issued and/or distributed in mainland China by governments, agencies, and state-owned enterprises.

Goldsborough noted that while other ETFs, such as Invesco's DSUM track yuan-denominated bonds traded outside mainland China, CHNB is the first to provide direct access to the nation's onshore bond market. "I give them real props for coming up with it," he said. "What Global X is doing is really interesting."

Mishra pointed to the size of the Chinese domestic bond market—third largest in the world—in explaining CHNB's potential. "This ETF could be a good option for investors seeking high income and diversification in their portfolios, as bond yields in China are much higher compared to U.S. and these securities have low correlations to other popular asset classes. Further, the credit quality is good and the Chinese currency, being nonconvertible, has much lower volatility compared with most other emerging markets currencies."

She urged patience, however. "I would recommend waiting for some time before investing in this ETF, in view of the weakness seen in the Chinese economy, risks emanating from high leverage in Chinese financial markets and steps being taken by the government to address those risks."

CHNB is one of several Chinese bond ETFs coming to market on the cusp of 2015.

Self-driving investments

ARK's Industrial Innovation ETF (ARKQ) launched Sept. 30 with a .95 percent expense ratio. It holds $9 million. This is an actively managed fund that invests in companies benefiting from automation and other technological advances in areas such as self-driving vehicles, 3-D printing, nanotechnology and manufacturing automation.

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"ARKQ is a tough fund to love," Hougan said. "Theoretically a take on automation—including red-hot areas like 3-D printing—its actual portfolio is chock full of big-cap tech companies (like) Google, Monsanto and Amazon. Those firms may benefit from automation, but their stock performance will be driven by a wide variety of factors, and I fear automation won't be their core driver. With niche ETFs, you want pinpoint exposure; it's not clear to me that that is what you're getting here."

Goldsborough, however, praised ARK's management team. "They're thoughtful and have a solid track record," he said. "With active ETFs, you're buying the management, not just the fund."

Storm clouds

ARK launched Web x.0 ETF (ARKW) on Oct. 7, a week after ARKQ. It, too, has a .95 percent expense ratio but trails its older sibling in size, with only $8 million under management. ARKW is actively managed and invests in companies seen as shifting away from hardware and software toward cloud computing and mobile technology.

"Next-generation Internet stocks trading at an aggregated price-to-earnings ratio of 89? What could go wrong?" Hougan quipped. "Seriously, though, this is a reasonable ETF that you can think of as cutting-edge technology in a box. Today's modern technology industry includes a huge variety of firms, from sleepy giants of yesteryear like Microsoft to au-courant firms like Facebook. This ETF solves that, taking only the hipsters and ignoring the grunge-era megaliths. Our biggest worry is the 0.95 percent expense ratio; that's a hefty hurdle for ARK's active management process to overwhelm."

Rosenbluth agreed that actively managed ETFs can be pricey. "This is a scale business," he said. "It's not necessarily a reason to avoid these funds, just something to consider." He was curious, though, about its holdings. "They have traditional tech companies, like Apple and Facebook, but also Disney and Charles Schwab. … There's not a straight line between them."

Both ARKW and ARKQ seek to benefit from the growth potential for disruptive technologies," Mishra noted. "While both these ETFs focus on very promising areas, their future success will depend on stock selection skills of their managers."

When niches have niches

Exchange Traded Concepts launched the Emerging Markets Internet & Ecommerce ETF (EMQQ) on Nov. 13. It tracks an index of Internet and e-commerce businesses from the emerging and frontier markets. EMQQ charges .86 percent fees and has $3.4 million under management.

"It's a really solid idea," Goldsborough said. "Investors are interested in these areas, but it'd be hard to invest in these companies individually,"

Mishra lauded the ETF's potential. "With a fast-expanding middle class, rising incomes and growing use of Internet/smartphones, the e-commerce markets in emerging countries look set to grow exponentially in the coming years. Further, many of these Internet/e-commerce companies are listed only in the U.S. and hence they are not included in broader emerging markets ETFs," she added.

Hougan also praised the fund, but urged prudence. "The big risk here is that people get too excited," he said. "You should think of this ETF like a hot pepper: A little bit sprinkled into your food could be great, but making it 50 percent of your dish could lead to trouble."