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7 classic portfolio lessons from extreme investments

Large, established fund companies dominate the core asset classes. That's why more managers are creating funds in ever narrower slices of the market.

"When I first entered the securities industry in 1990, investing in assets like Russian stocks, frontier markets, emerging market debt and even junk bonds were considered the purview of the most sophisticated investors," said Mitch Goldberg, president of the investment firm ClientFirst Strategy. "What regular everyday investors can [now] do is nearly limitless."

A parachutist jumps from a 365 metre-high platform at Ostankino TV tower in Moscow
Sergei Karpukhin | Reuters

This "limitless" choice, now close to 2,000 exchange-traded funds, serves an unintentional purpose: It can reinforce for investors the keys to building a successful portfolio. These rules don't change even if the number of investments does.

The first lesson, and the most obvious, is that abundance isn't always a positive. "Some ETFs really are unique, and some seem a little too unique," Goldberg said.

We spoke to experts to identify essential investing lessons learned by taking a look at some of the most narrowly defined fund options.

1. Stock overlap: Do you know how different your fund is from cheaper ones?

Accessing niche sectors through pure-play funds is becoming more common, and in the case of PureFunds Video Game Tech ETF (GAMR), which launched in March, its game has been on. It tracks a global index of companies involved in video games and is the first pure play in its niche. It is not cheap, with an expense ratio of 75 basis points. Initial performance has been strong, with returns of 6 percent since its launch in March, but such a short performance window should never be high on the "pros" list of any investor.

What matters is whether the concept makes investing sense longer-term. "Pure play for niches are always hard to get," said Paul Britt, senior ETF research analyst at FactSet Research Systems. "GAMR's logic is reasonable in this respect."

The logic is reasonable because the video game stocks that this fund is investing in do not overlap to a significant degree with stocks in broader U.S.-based technology funds.

Todd Rosenbluth, director of mutual fund and ETF research at S&P Global Market Intelligence said GAMR is global, and most tech funds are not. Two of the biggest tech ETFs — the SPDR Technology Select Sector (XLK) and PowerShares QQQ (QQQ) ETF — are virtually all U.S.-listed stocks. U.S. market exposure is 45 percent of GAMR.

"If you're paying 50 to 60 basis points more than a diversified fund, you have to hope and expect to get that, and then some, back on an annualized basis," Rosenbluth said.

Neena Mishra, director of ETF research at Zack's Investment Research, noted that PureFunds' breakthrough Cyvber Security ETF (HACK) raised an impressive amount of money and was timed perfectly to take advantage of enthusiasm for newly public cybersecurity firms, but it has struggled more recently. "Anything above 50 to 60 basis points and it is really hard for an ETF to outperform a broader index fund," Mishra said.

2. Are you a trader or investor?

There are plenty of narrow investments that make sense for traders who can (or think they can) time the peaks and valleys in volatile sectors such as commodities. For most investors, that's going to be a bad bet.

Global X's Fertilizers/Potash ETF (SOIL) tracks a global index of fertilizer producers. It's down more than 27 percent over the past 12 months and has gathered only $9.3 million since its launch five years ago. It's up 5 percent over the past three months.

"Traders with a shorter-term investment focus are more likely to use this," Rosenbluth said. And that's the way it should be. He drew a comparison to GAMR: "It's easier to look out and see mobile or gaming growing in 10 years versus a 10-year use case for more mature industries, like fertilizer."

Van Eck's Market Vectors Coal ETF (KOL) is up almost 26 percent year-to-date but has posted an 83 percent decline over the last five years. "Does the supply-and-demand equation for coal look bullish long-term?" Goldberg asked. "And does the world have ample supplies of it? I think the market has spoken to that already."

3. Are you a yield seeker? Have you analyzed the risk and reward in the bond markets as you stretch?

Everyone is stretching for yield, but there's always a trade-off between risk and reward that applies to investing in high-yield bonds — and international bond markets, specifically.

The iShares' Currency-Hedged International High-Yield Bond ETF (HHYX) tracks an index of high-yield bonds from developed foreign markets and hedges against currency fluctuations. The fund is up 4 percent year-to-date but has gathered only $8.8 million since launching in 2015.

Britt said that searching for yield in a zero- and negative-interest-rate policy world makes sense but noted that high-yield bonds carry risk, and the baseline for yield is lower in many foreign countries than it is in the United States. "I can imagine a small allocation to it in a yield-seeking portfolio with higher risk tolerance," Britt said.

Mishra said the ETF's yield of 2.29 percent couldn't be called impressive, but the central bank's move to continue lowering rates overseas could mean that this ETF performs better than a U.S. high-yield bond fund.

Gary Gordon, president of financial advisory firm Pacific Park Financial, said the search for yield can be difficult if not damaging. One need only look at the return generated by the $12 billion SPDR Barclays Capital High Yield Bond ETF (JNK), a flagship in the high-yield market, which has generated virtually no return in the past three years.

4. Don't be swayed by what was once 'hot' with institutions.

Credit default swaps for everyone? Apparently not.

The CDS North American HY Credit ETF (TYTE) launched in the summer of 2014 as the only ETF to offer credit exposure through credit default indexes to the North America high-yield market. "This was once only found in the hands of large and sophisticated hedge funds," Goldberg said. "I doubt too many retail investors are asking how they could bet on a potential credit default."

He's right. The fund accrued less than $2 million as of April and closed in May due to limited investor interest.

"Unique doesn't mean you need it," Mishra said.

An institutional concept, especially on the fixed-income side of the market, may not catch on with the investing public, and that can lead to a lack of liquidity and trading volume, which can become big issues. Gordon advised that when searching for yield, an investor needs to start with the premise that the investment will trade enough.

"ETFs like JNK have greater liquidity and you're not missing the boat," Gordon said.

5. Be careful about doubling down on risk, and correlation.

Emerging markets + technology? Hmm ...

Exchange Traded Concepts' Emerging Markets Internet & Ecommerce ETF (EMQQ), is largely true to its name, tracking an index of web-related businesses from emerging markets, like China, Russia and South Africa. But the fund's fees are a substantial 86 basis points; it's down 5.8 percent year-to-date and 13 percent over the last year. Britt noted that EMQQ could leaven a broad emerging markets basket, in which its holdings might be underrepresented. The Vanguard Emerging Markets ETF (VWO), which holds near-4,000 stocks, shares only nine stocks with EMQQ, which holds 48 stocks in all. The iShares MSCI Emerging Markets ETF (EEM), which holds close to 850 stocks, shares 17 stocks with EMQQ, according to Morningstar data.

But Mishra noted that a problem with applying a technology screen to emerging markets is concentration — because so few Indian companies have gone public, this ETF will have most of its stock exposure to the Chinese market (roughly 62 percent of the ETF). EMQQ does indirectly access the Indian start-up market including darling FlipKart and other Indian e-commerce companies through investment in venture firm Naspers, a big Flipkart shareholder.

Rosenbluth said the combination of riskier sector and riskier geography has to be weighed against the significance of the growth opportunity and the correlation that a fund like EMQQ has with a broader regional fund. The exposure to technology in a more diverse EM fund will be limited or offset by exposure to mature sectors, like financials and commodities, but that doesn't mean correlation won't be high, and all emerging markets stocks trade based on similar factors and market sentiment. In fact, according to Morningstar, EMQQ has a correlation to the MSCI emerging markets index of 0.84 since December 2014 (a correlation of 1.0 is a "perfect score"; the non-correlation an investor should look for is between 0 and -1.)

Kevin Carter, CEO of Big Tree Capital and founder of EMQQ, stated his fund's case simply: "EM e-commerce is the best growth story in the world." He pointed to performance of First Trust's Dow Jones Internet Index ETF (FDN), a domestic point of comparison, versus the S&P 500. FDN is up 15 percent in the past 5-year period, according to Morningstar, which puts it ahead of the S&P 500. "The internet is happening and it's a big deal. And after all, what's riskier, putting 30 percent of your investments in state-owned enterprises like Petrobras or investing with entrepreneurs with U.S. institutional backing that trade on the best and most transparent exchanges in the world?" Carter said.

For most investors, a broad emerging markets fund is a small slice of an overall portfolio relative to developed market stocks and bonds, so a fund like EMQQ should be even smaller than that exposure. "If this is your EM equity exposure, then you're taking on a bet that is probably not wise," Rosenbluth said.

6. Rooting for the home team won't influence the game's outcome.

There's a lot of research on fantasy sports addicts valuing players on their own teams higher than they would if the same player was on another person's team. That research isn't limited to fantasy sports, either. And now it has a parallel in the world of fund investing. And it may see more, especially amid the start-up booms taking place in many cities across the United States.

LocalShares' Nashville Area ETF (NASH) tracks publicly traded companies based in and around Nashville, Tennessee. The fund is down 17 percent over the last year but is up 5 percent since inception in August 2013. Yet it's only attracted only $11 million.

"While I can understand the rationale behind some of the new launches that are focused on very unique corners/niches of the market that have excellent growth potential, I do not see any reason for investing in companies based in a particular city," Mishra said. "Even if investors love Nashville, I doubt they'll see a case for investing in such a narrow geographic focus ETF."

There's a broader lesson here: Don't become attached to any stock in your portfolio, let alone inflate its value, just because it's "yours." A disciplined buy-and-sell strategy (with the emphasis on the selling when the time comes) is critical.

7. Funds fail, size matters.

Britt noted that lots of funds file but never launch. Lots of funds launch and fail, with taxable consequences. There have already been 26 ETF closures this year, according to ETF.com.

Any fund that has raised less than $25 million after at least three months on the market has a liquidation risk that is high, Mishra said.

The classic example fund-watchers point to is HealthShares, which launched more than a dozen funds targeting medical and drug trends in the late 2000s but went under swiftly.

"Go back and look at all the hype," Gordon said. "It ended up with all things going under because there was no liquidity."

Mishra said there is a better chance that a bigger fund company, like an iShares, sticks with a dog for longer because the economics of that fund won't be important to its overall financial performance.

Gordon said that for investors who think they can properly use narrow investments, "Wait for a big fund company's version of the esoteric fund. ... The very biggest of families will let things that should have died exist for years."

— By Joe D'Allegro, special to CNBC.com