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Boom in niche ETFs powers passive investor portfolio plays

These days, there's apparently an exchange-traded fund for everyone.

The proliferation of niche ETFs, which track a concentrated market segment, such as real estate or commodities, has given passive investors unprecedented power to make tactical plays with their portfolios.

Niche funds, which can potentially outperform traditional ETFs but also involve greater risk, allow retail investors to tilt for increased income, tax efficiency or interest-rate protection.

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"We see more investors using ETFs to diversify into different types of credit exposure, like high-yield bonds, and many are also starting to look at preferred securities, which are generally less risky than common stock but often more high risk than fixed-income securities," said Jane Leung, an iShares asset allocation strategist for BlackRock, noting preferred stocks also provide diversification benefits, as they are less correlated with the broader market.

"Investors are using tactical allocation to express their market views," she said.

The growing demand for outcome-oriented strategies, in fact, has given rise to a new breed of asset manager, called ETF investment strategists, who typically work with financial advisors to help clients maximize returns and minimize risk in their ETF portfolios. In effect, they are ETF funds of ETFs.

"ETFs allow investors to reach out and gain exposure to particular asset classes, like emerging or frontier markets, in a low-cost diversified fund," said Jared Watts, portfolio manager for Morningstar Investment Management, an ETF strategist.

According to fund tracker Morningstar, some 1,800 U.S.-listed ETF products exist, deploying everything from diversified core holdings to inverse, or hedge fund–like strategies. Many use a combination of strategies, and not all are appropriate for retail investors, Watts said.

"If you look at numerous trends, you'll see a lot of overlap in the categories of what's being recommended to individual investors," he said.

The following, however, offers a snapshot of the most commonly used strategies for ETF investors.

Core and explore. Also known as core-satellite, core-and-explore strategies describe a portfolio in which an investor's strategic asset allocation is anchored by broad asset classes (stocks, bonds and cash) according to their investment objective, time horizon and risk profile — such as 80 percent equities and 20 percent bonds.

To construct their core position, which may consist of 80 percent equities and 20 percent fixed income, they may use low-cost, passively managed ETFs that track the major market indices.

"Buy-and-hold investors, or those planning for long-term goals and wealth creation, would be best suited to consider broadly diversified core holdings in their portfolios." -Jane Leung, iShares asset allocation strategist for BlackRock

Separately, however, they would also create a satellite ETF portfolio for tracking more narrow segments of the market, which enables them to invest in undervalued sectors and potentially achieve a higher risk-adjusted return, while still keeping their expenses under control.

A number of ETF strategies exist under the core-and-explore header. Among them is sector rotation, in which the investor attempts to determine which segments of the economy are likely to be strongest based on business cycles, economic trends and seasonal patterns, and invest in ETFs related to those markets. Theoretically, investors who do so should be eking out higher returns than their buy-and-hold counterparts.

At the same time, investors might deploy a risk-on/risk-off strategy using quantitative models and market views to determine when to take risk off the table and when to use it to their advantage.

Those with concentrated positions in a specific stock may also add diversification by selling a percentage of those shares and using the proceeds to purchase an ETF that tracks the sector. This helps reduce volatility and risk in their overall portfolio.

With interest rates projected to rise, said BlackRock's Leung, many investors are also turning to certain sectors of the market that are less vulnerable to interest-rate hikes.

"We're starting to see investors turning to the financial and technology sectors because they have such huge cash reserves and they're less vulnerable to rising rates," she said. "In the financial sector, higher rates mean banks can charge more for what they loan to their clients, so they're poised to do quite well in a rising rate environment."

Active/passive. Core-and-explore strategies are not to be confused with active/passive, said Morningstar's Watts, in which the investor's large capitalization stock holdings are anchored by low-cost, passive ETFs, while their allocation to small caps and foreign markets is entrusted to actively managed funds.

Such a strategy is predicated on data that suggests even the best fund managers have trouble beating their benchmarks in the most efficient and transparent markets, such as large cap U.S. stocks.

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Statistically, they have a higher probability of generating alpha (a higher return) in less-efficient markets, such as emerging markets equity and domestic small caps.

"This is a popular strategy that we've seen both individual investors utilize, as well as investment advisors and strategists," Watts said. "Investors may be better off using more passive investments, such as ETFs, for the most efficient markets, as opposed to paying a higher fee."

Leverged/inverse. Inverse ETFs and leveraged ETFs allow investors to hedge their bets against inflation, foreign currency fluctuations and market drops.

Such funds use derivatives and other sophisticated investment strategies to provide inverse exposure to equities. They are designed to profit from a decline in the value of an underlying benchmark, much like shorting a stock. Among them: ProShares Ultra MSCI EAFE, Direxion Daily S&P 500 Bear 3X Shares and VelocityShares 3X Inverse Gold ETN.

Smart beta all the rage

Leung at BlackRock noted, however, that inverse funds are best left to the most sophisticated investors. "It is important that any investor considering inverse and leveraged funds understands exactly what they are meant to do and the mechanics of how they do it," she said. "This is not always clear, and as such, I do not think they are better suited for more sophisticated investors and/or institutions."

Smart beta. In the world of ETFs, smart beta is all the rage. Such strategies seek to capture market inefficiencies by using metrics other than market capitalization — such as volatility, earnings, revenue, momentum or dividends — to weight the holdings within their fund.

Momentum is one such strategy in which fund managers factor in the relative strength of individual sectors, overweighting those that show the strongest performance over a specific time frame and underweighting those that show weakness.

"Momentum is a very popular tactical strategy right now ... but absent sophisticated data sets, it can be hard for individual investors to take advantage of," said Watts.

Low volatility ETFs are another. With market volatility here to stay, Leung explained, many conservative investors are flocking to products that help to minimize downside risk, including minimum-volatility ETFs.

Such funds, including PowerShares S&P 500 Low Volatility Portfolio and iShares MSCI USA Minimum Volatility ETF, invest in securities with low-volatility characteristics (stable share prices and higher-than-average yields.)

"There are a lot of clients starting to look at minimum-volatility products coming out," said Leung, noting part of the allure is that they help investors stay the course amid market turbulence.

Indeed, average investors are notoriously lousy at timing the market. When the going gets tough, mom and pop tend to bail, and they hop back in when the market heats up — thus ensuring a pattern of buying high and selling low.

"On the retail side, emotions tend to drive investment decisions, which is the opposite of what you want," Leung said. "You end up with lackluster performance."

Cash equitization. Investors who are holding a large temporary cash position — due to a year-end bonus, proceeds from the sale of a business or distribution from their retirement account — but aren't ready to make a long-term bet on the market can instead "equitize" their cash by buying a core ETF. By purchasing an ETF that tracks a major market index, the investor ensures they don't miss out on any market gains while they decide which speculative investments they wish to make.

Buy and hold. Not all investors, of course, have tactical ambitions.

Those who are in it for the long haul and have the discipline to weather market storms may be best suited for broadly diversified core holdings, said Leung. Such funds include iShares Core S&P Total U.S. Stock Market ETF, Vanguard's Total Stock Market ETF and iShares' International Aggregate Bond.

"Buy-and-hold investors, or those planning for long-term goals and wealth creation, would be best suited to consider broadly diversified core holdings in their portfolios," Leung said. "Equities are an important component in such an investor's asset allocation, in order to hedge against inflation and preserve their purchasing power in the future."

Whether buy-and-hold, tactical or somewhere in between, investors who deploy ETF strategies to pursue higher returns should research each fund carefully and understand the risks. They should also know their limitations.

"A lot of investors combine these various strategies and try to go for a long-term approach but unfortunately fall into the short-term trap," said Watts at Morningstar. "They try to time the markets, to their detriment.

"So, while individual investors do pursue these strategies, it doesn't mean that it always benefits them," he said.

— By Shelly Schwartz, special to CNBC.com