Choosing The 'Best' Technology ETF

Summary

• Over the bear-bull cycle since 2007, QQQ has outperformed the general stock market on a risk-adjusted basis.
• Technology ETFs have been more volatile than the overall stock market, but have not always delivered better returns.
• Technology ETFs are highly correlated with one another and with the S&P 500.

Technology has been an exciting but volatile sector over the past three decades. In the 1980s, the mainframe computer was replaced by the personal computer and Microsoft (NASDAQ:MSFT) began to dominate the operating system market with the introduction of Windows. The 1990s were the "go-go" years as the Internet became of age and all "dot com" companies flourished. The bubble finally burst shortly after the beginning of the millennium and hundreds of companies went out of business. However, some of the strongest Internet companies not only survived, but thrived and have become dominant players over the more traditional "brick and mortar" businesses.

There is no doubt that tech companies have changed our lives, but have they been good investments? To gain insight into the investment aspects of technology, this article will explore the risks and rewards associated with Technology ETFs to see which fund has performed the "best." There are many ways to define "best." Some investors may use total return as a metric, but as a retiree, risk is as important to me as return. Therefore, I define "best" as the asset that provides the most reward for a given level of risk, and I measure risk by the volatility. Please note that I am not advocating that this is the way everyone should define "best"; I am just saying that this is the definition that works for me.

Among the 35 ETFs focused on Technology, I have limited my analysis to those that have a daily average trading volume of at least 100,000 shares and have over $200 million in assets. In addition, I chose only funds that were in existence during the 2008 bear market so that I could judge performance over a complete bear-bull cycle. The following ETFs met my selection criteria. I will look first at ETFs that cover the entire technical landscape and then narrow down to a few more specialized ETFs.

Overall technology ETFs

• Technology Select Sector SPDR ETF (NYSEARCA:XLK). This ETF is the most liquid of the exclusive technology plays, trading over 8 million shares per day. It has a high-quality portfolio of 74 holdings weighted by market cap. The portfolio is spread among many sub-sectors including computers (20%), software (18%), Internet software and services (16%), IT services (15%), telecom (11%), and semiconductors (11%). The fund is top heavy with the top 10 holdings making up 58% of the portfolio. It has an expense ratio of 0.15% and yields 1.8%.
• Vanguard Information Technology ETF (NYSEARCA:VGT). This ETF is more broad based than XLK and tracks 393 stocks spread across computers (20%), software (20%), IT services (16%), Internet software and services (17%), semiconductors (13%), and communications (8%). The fund is also relatively top heavy with the top 10 holdings making up 55% of the portfolio. It has an expense ratio of 0.12% and yields 1.1%.
• iShares U.S. Technology ETF (NYSEARCA:IYW). This ETF tracks the cap-weighted Dow Jones U.S. Technology Index that is comprised of 144 companies. The top sub-sectors are software (24%), Internet software and services (17%), semiconductors (15%), telecom (10%) and IT services (7%). The top 10 holds make up 63% of the portfolio, but the fund also holds 17% in small- to mid-cap companies. The expense ratio is 0.45% and the yield is 1.1%.
• First Trust Technology AlphaDEX (NYSEARCA:FXL). This ETF tracks the StrataQuant Technology Index, which is a proprietary algorithm that selects technology stocks from the Russell 1000. Stocks are ranked and weighted based on growth and value factors. The ETF holds 89 companies and the constituents are re-evaluated quarterly. Semiconductors are the largest sub-sector at 22% followed by electronic equipment (19%), software (18%) and communications (12%). The expense ratio is 0.67% and yield is 0.6%.
• Guggenheim S&P Equal Weight Technology ETF (NYSEARCA:RYT).This ETF tracks the S&P Information Technology Equal Weight Index. The ETF holds 67 stocks. Semiconductors are the largest sub-sector (24%) followed by IT services (23%), software (17%), and internet software and services (11%). The expense ratio is 0.43%, and the yield is 1.2%.

Software sub-sector. Computers are now ubiquitous, but they are virtually powerless without software to tell them what to do. The newest innovation is cloud computing, where your software can be obtained on-demand from the Internet rather than running on your local computers. The major ETF devoted to software is:

• iShares North American Tech-Software ETF (NYSEARCA:IGV). This ETF tracks the S&P North American Technology Software Index, which has 58 cap-weighted holdings. The top 10 holdings make up 57% of the portfolio. The expense ratio is 0.48%, and the yield is 0.25%.

Networking sub-sector. The networking sub-sector includes both local area networks (LANs) and Wide Area Networks (WANs) that allow computers to exchange data. The best-known network is the Internet, which has revolutionized commerce and information retrieval. Networks have become an indispensable part of our lives and have spawned numerous social media sites. The ETF selected to represent this space is:

• First Trust DJ Internet Index ETF (NYSEARCA:FDN). This ETF tracks the cap-weighted Dow Jones Internet Index. It has 41 holdings focused on large Internet companies with the top 10 companies making up 52% of the portfolio. The companies selected for this portfolio must derive at least 50% of their revenue from the Internet. It has an expense ratio of 0.60% and does not have any yield.

Reference ETFs

• PowerShares QQQ Trust ETF (NASDAQ:QQQ). This ETF is not a pure technology play since only about 60% of the assets are devoted to technology. However, QQQ is often equated with the technology sector, so I will use this ETF as a benchmark for assessing performance of other ETFs. QQQ is comprised of the 100 largest non-financial companies listed on the NASDAQ, and the top 10 holdings make up 47% of the portfolio. QQQ trades over 30 million shares per day, has an expense ratio of 0.20%, and yields 1.1%.
• SPDR S&P 500 Trust ETF (NYSEARCA:SPY). To compare the technology sector to the general stock market, I have included SPY. This ETF tracks the 500 stocks in the S&P 500, has an expense ratio of 0.09%, and yields 1.9%.

To evaluate the risks and rewards of these technology ETFs, I plotted the rate of return in excess of the risk free rate (called Excess Mu on the charts) versus the volatility of each ETF. I used a look-back period from October 12, 2007, (the market high before the bear market collapse) to April 2015. The results are shown in Figure 1 and were generated using the Smartfolio 3 program.

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Figure 1: Reward and risk over the bear-bull cycle

The figure indicates that there has been a wide range of returns and volatilities associated with technology. The Internet fund generated the largest rate of return, but at the expense of increased volatility. Was the increased return associated with Internet stocks worth the increased volatility? To answer this question, I calculated the Sharpe Ratio for each ETF.

The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. On the figure, I also plotted a red line that represents the Sharpe Ratio of QQQ. If an asset is above the line, it has a higher Sharpe Ratio than QQQ. Conversely, if an asset is below the line, the reward-to-risk is worse than QQQ. Similarly, the blue line represents the Sharpe Ratio associated with SPY.

Some interesting observations are apparent from the plot.

• QQQ was slightly more volatile than SPY, but also provided significantly more return. Thus, over the bear-bull cycle, QQQ handily outperformed SPY on a risk-adjusted basis.
• FDN had the best risk-adjusted performance with QQQ close behind.
• All the technology ETFs were more volatile than the overall market, but also provided more return. On a risk-adjusted basis, all the technology ETFs beat SPY.
• With the exception of the Internet ETF, technology ETFs were tightly bunched on the risk versus reward plane.

Since all the ETFs are from the technology sector, I next wanted to see if you gained any diversification by purchasing more than one of the funds. To be "diversified," you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the funds, and the results are shown in Figure 2.

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Figure 2. Correlation matrix over the bear-bull cycle

The figure presents what is called a correlation matrix. The symbols for the funds are listed in the first column on the left side of the figure. The symbols are also listed along the first row at the top. The number in the intersection of the row and column is the correlation between the two assets. For example, if you follow XLK to the right for three columns, you will see that the intersection with IGV is 0.918. This indicates that, over the bear-bull cycle, the price of XLK and IGV have been over 91% correlated. Note that all assets are 100% correlated with themselves, so the values along the diagonal of the matrix are all ones.

The matrix shows that the technology ETFs are typically highly correlated with each other and also with QQQ and SPY. The equal weight ETF is the least correlated, but even here, the correlations range from 76% to 99%. This indicates that you do not receive much diversification by purchasing more than one of these funds. This is not too surprising given that there are only so many large-cap technology companies, and these are prominent in most portfolios within the technology sector and as well as the general market.

Technology is a rapidly changing sector, and the darling in one time period may not persist, as new inventions are brought to market. To determine if the bear-bull trend has endured into the more recent past, I generated another plot with a 3-year look-back period. For this analysis, I was able to add a couple of new ETFs in the semiconductor space.

The semiconductor sub-sector makes the chips that are a key part of most electronics. The main technology challenges in chips are how to make them smaller, use less power, and be more reliable. The major ETFs in this space are:

• iShares PHLX SOX Semiconductor Sector Index ETF (NASDAQ:SOXX).This ETF tracks the Philadelphia Stock Exchange (PHLX) Semiconductor Index (SOX). There are 31 cap-weighted stocks in the index, with 58% of the total assets concentrated in the top 10 holdings. The fund has an expense ratio of 0.47% and yields 1.6%.
• Market Vectors Semiconductor ETF (NYSEARCA:SMH). This ETF holds 25 of the largest semiconductor companies. Prior to being taken over by Market Vectors in 2011, this EFT was the Merrill Lynch Semiconductor HOLDR. The fund has an expense ratio of 0.35% and yields 1.1%.

The plot of the 3-year look-back period is shown in Figure 3, and as you might have expected, there have been significant changes.

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Figure 3: Reward and risk over the past 3 years

During the past 3 years, both SPY and QQQ have been in rip-roaring bull markets. The sector funds have generated excellent returns, but have not been able to keep pace with either SPY or QQQ. The Internet ETF continued to outperform the other technology sectors, and the semiconductor ETFs, SOXX and SMH, were also in the forefront in terms of Sharpe ratio. The equal-weight ETF had good performance with less volatility.

To complete the assessment of technology ETFs, I looked at the past 12 months. The results are shown in Figure 4. During this period, SPY faltered, so QQQ easily outperformed. Interestingly, the Internet ETF fell from grace and booked the worst risk-adjusted performance. The other technology ETFs were all closely bunched in terms of Sharpe Ratio.

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Figure 4: Reward and risk over past 12 months

Bottom Line

Which was the best Technology ETF? To my mind, QQQ would have been the best selection even though it is not a pure technology play. If you want to stick to technology, the best performers depended on the time frame. FDN had been a standout until the last year. The semiconductors have done well, but they do not have a long history.

If I had to pin the rose on a pure technology ETF, I would choose the equal-weight RYT. It has shown more consistency than the other funds. This is likely because small- and mid-cap companies tend to do well in a bull market, but no one knows what the future will hold. Since 2009, we have been in a phenomenal bull market, so past data may not be a good predictor of the future.

Source : - seekingalpha