Understanding Tech ETFs

Joel Anderson  |

Investing in tech stocks is usually all about risk. Tech is a cyclical sector with opportunities for rollicking returns in big markets and equally big slumps in trying times. What’s more, typically when one thinks about a tech investment, it’s in a single company. A single big idea, like the hot new social media platform or a company growing algae that can eat plastic waste and turn it into ice cream, that will catapult that company into the stratosphere and make its investors multi-millionaires.

As such, tech ETFs seem to be a little backwards. The whole point of an ETF is the ability to mitigate risk and track an industry or sector collectively. So why jump into the riskiest sector out there? While it may seem somewhat different, tech ETFs are their own breed and offer their own advantages and disadvantages.

Like pretty much any other type of ETF, really.

Concentrated Holdings

One distinct characteristic for many tech ETFs is now that their holdings are more and more concentrated into a handful of companies. While the phrase “tech company” can often drum up images of tiny start-ups run by a handful of ambitious nerds, the reality these days is that massive companies like Apple (AAPL) and Google (GOOG) represent the lion’s share of the sector.

As such, an investment in an ETF that tracks a cap-weighted tech index could have a lot more exposure to a select few companies than one would normally be comfortable with.

Technology Select Sector SPDR Fund ($XLK)

The most actively traded tech ETF is the SPDR fund that tracks the S&P Technology Select Sector Index. No surprise there, really. But it illustrates the concentration of the tech sector into its top players well. Apple makes up 15.43 percent of the fund’s holdings, Google 9.16 percent, and Microsoft (MSFT) 8.47 percent. Along with AT&T ($ATT) and IBM (IBM) each coming in at about 5.5 percent, that means the top holdings for XLK represent a combined 44.1 percent of the entire portfolio.

Which begs the question: what’s the point in investing in an ETF at that point? When nearly half your exposure is to just five companies, it seems more like a pretty straight-forward play on those companies with a few other stocks mixed in.

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And a quick look at XLK’s performance over the last year would indicate that this concern is a valid one. Year-to-date, XLK’s gained just 19.48 percent against the 26.12 percent jump for the S&P 500 as a whole. With so much exposure to just a few blue-chip companies, is it possible that an XLK owner is missing out on the gains they could be making for exposure to a cyclical sector like tech?

The picture changes some, though, if you extend that to five years. Over that period, XLK’s up 125.21 percent to the S&P’s 104.48 percent. So it appears as though this year’s rally seemed to leave behind the tech sector. This could be because the biggest gains for these major players came prior to this year, but it does seem to indicate that, at least in the long term, tech stocks have outperformed during the long recovery.

Other Options for Tech ETFs

Of course, another antidote for the big exposure to those specific companies could be getting more specific in the ETF one uses for their tech play. The Market Vectors Semiconductor ETF ($SMH) is the second-most actively traded ETF (at about a sixth the average volume of XLK), and it’s focused on the semiconductor industry with no exposure to Apple or Google.

Granted, in many ways this is just trading Apple and Google for Intel (INTC) (19.29 percent of holdings) and the Taiwan Semiconductor Manufacturing Co. ($TSM) (13.09 percent of holdings), but it’s still a very different play on the economy and markets than XLK.

However, combined with other industry-specific ETFs like the iShares S&P GSTI Software Index Fund (IGV) , the First Trust ISE Cloud Computing Index Fund ($SKYY), the PowerShares NASDAQ Internet Portfolio (PNQI) , or even the Global X Social Media Index ETF ($SOCL), one has multiple options for spreading their exposure around across different parts of the sector.

One can even look overseas with ETFs like Guggenheim China Technology ETF ($CQQQ).

Tech ETFs Can Be an Intriguing Play

Ultimately, depending on the exposure you’re looking for, XLK might be just the sort of bet you’d like to make: heavy on a few big players but in combination with a variety of other stocks. Alternately, one might be more interested in sticking to specific industries and segments and staying away from the sector’s biggest, most well-known companies.

However you want to play it, there’s probably an ETF, or a basket of ETFs, that can suit your needs.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer.


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