June 30, 2005

Tech ETFs Move Into the Spotlight

While some mutual fund managers might have scaled back on the volatile technology sector, loyal tech investors seeking to better control or increase their exposure to the sector have a new tool at their disposal, namely exchange-traded funds.

Not only do many ETFs track popular technology indexes and even sub-indexes, they are inexpensive to own, provide immediate sector exposure, and can be bought and sold intraday or sold short by savvy investors looking to make tactical sector bets. In addition to this trading flexibility, ETFs can also be held for the long haul, like open-ended index mutual funds.

Scott Kessler, Director of Information Technology Equity Research at Standard & Poor's, takes issue with those who refrain from technology stocks on the basis of poor fundamentals. In fact, he finds valuations reasonable, and fundamentals improving to the point where interest in the sector is again reviving. In May in fact, technology stocks outperformed broad market, rising nearly 8%. Year to date as of the end of May, however, tech stocks are still under water, having slipped 4.3%.

Currently, Kessler and his group are emphasizing several themes within IT, one of which is data storage. Demand is being fueled by regulations mandating the backup of information, as well as by popular portable devices such as Apple Computer's (AAPL) iPod, digital cameras, and cell phones. EMC Corp. (EMC), the leading supplier of enterprise data storage systems and software, saw revenues soar 32% in 2004. Internet advertising is another promising area. Revenues in the segment have grown significantly as companies such as Yahoo (YHOO) and Google (GOOG) connect advertisers with online users through keyword searches and other targeted methods.

In addition, Kessler believes online security will likely continue to be a strong performing area, due in part to lapses in consumer privacy, and rising incidents of identity theft/fraud. Examples of companies in this segment include McAfee (MFE), and Check Point Software (CHKP). Increasing trends in telecommuting and online meetings has spurred demand for remote functionality and the need for solid web access infrastructure. Overall, Kessler emphasizes stocks of quality large-cap technology companies since they often have better brands, more diversified business models, and stronger balance sheets. Many of them will be less impacted than their smaller-cap counterparts when they begin expensing stock options in 2006.

Among ten technology ETFs tracked by Standard & Poor's, Goldman Sachs Networking Index Fund (IGN) clocks in with the highest three-year annualized return as of May 31, 2005. It rose 11.2% for the period, versus 5.6% for the S&P 500, and 5.2% for the S&P 500 Information Technology Index. However, this ETF is not for the feint of heart. Volatility is extreme, evidenced by its high three-year standard deviation, a historical measure of the variability of a portfolio's returns. (The higher an ETF's annualized standard deviation, the more volatile its returns.) That partly results from its very narrow focus: It invests roughly 87% of its assets in networking and related issues, and about 13% in semiconductors. Among its top holdings at the end of May were Corning (GLW), QUALCOMM (QCOM), and Research in Motion (RIMM). In addition, the top ten stocks in this ETF accounted for close to 75% of the portfolio at the end of May, making it a very concentrated offering.

At the bottom of the list falls Goldman Sachs Semiconductor Index Fund (IGW), which lost 3.6% annualized over the last three years due largely to lackluster performance among semiconductor stocks. Year to date as of the end of May, the portfolio slipped 0.7%, making it the "best" of the ten ETFs surveyed in terms of absolute performance. Still, this offering's narrow focus on semiconductor stocks, just one of technology's subsectors, makes it extremely volatile. Top holdings include Intel Corp. (INTC), Texas Instruments (TXN), and Motorola (MOT). Over 90% of the fund is invested in semiconductors. As of the end of May, the top ten positions made up 58.8% of the portfolio. In short, such narrowly focused ETFs like Goldman Sachs Networking Index and Goldman Sachs Semiconductor Index are more suitable for tactical market decisions given the high volatility, rather than for buy-and-hold investors.

Broader-based technology ETFs, such as the tech-dominated Nasdaq 100 Trust (QQQQ), which tracks 100 of the largest non-financial companies listed on the Nasdaq; the S&P Select Technology SPDR Fund (XLK), which holds the large, blue-chip technology shares in the S&P 500; and iShares Dow Jones US Technology (IYW), which tracks the tech stocks in the Dow Jones U.S. Total Market Index, offer more exposure to technology's subsectors, and make it easier to play themes like data storage, Internet advertising, and online security, or to focus on blue-chip names. Though they are still very volatile, their ups and downs are not as extreme as more narrowly focused tech ETFs that track mainly one specific industry within the sector.

However, even among broader-based tech ETFs there are still differences to be aware of. The Nasdaq 100 Trust, for instance, includes both domestic and international holdings, as well as stocks of some emerging technology companies and some non-tech sectors, while the S&P Select Technology SPDR Fund holds 90 U.S.-based large-cap tech issues without much exposure to the emerging technology space. The iShares Dow Jones U.S. Technology Fund holds nearly 260 stocks, the most of all the tech ETFs. While that number of holdings can help to dampen volatility relative to other tech ETFs, the offering is still fairly concentrated, with over 55% of its assets in its top ten positions. In contrast, the streetTRACKS Morgan Stanley Technology High Tech 35 ETF has only 36 holdings. It tracks the Morgan Stanley Technology Index, which is comprised of technology stocks of U.S. companies choosen from 11 subsectors.

Last week, three new tech ETFs entered the fray. In a twist on ETF investing, PowerShares Capital Management LLC is offering market and sector ETFs that attempt to beat their targeted indexes by selecting the "best" stocks in them, or investing in what it calls "Intellidex" indexes. These indexes were developed by the American Stock Exchange where the funds trade, with assistance from PowerShares. Companies are included or excluded from the indexes based on 25 factors such as cash flow, a stock's historical trading range, analysts' consensus estimates, and earnings growth. The indexes' component companies change quarterly, giving these so-called intelligent ETFs higher turnover than traditional indexed ETFs. PowerShares' new tech ETFs offerings based on the strategy -- PowerShares Dynamic Networking (PXQ), PowerShares Dynamic Semiconductor (PSI), and PowerShares Dynamic Software (PSJ) -- are too new to be tracked by Standard & Poor's.

Overall, sector investing poses risks, especially in high-beta cyclical sectors such as technology where the landscape changes rapidly, and products can quickly become obsolete. Merger and acquisition activity has been brisk, while macroeconomic factors can contribute to the category's volatility. ETFs that track broad market indexes and invest in a number of sectors, such as the S&P 500, as well as indexes based on growth or value criteria, are able to better absorb and spread out volatility. To be sure, tech ETFs, on average have been twice as volatile as large-cap growth funds over the past three years. Investors should first examine any tech exposure they might already have in their existing portfolios and their tolerance for risk before deciding to add tech sector ETFs.

Standard & Poor's currently has an underweight (13.4%) recommendation on information technology and a neutral fundamental outlook on the sector. Year to date through May 31, the S&P Information Technology Index, which represents 15.5% of the S&P 500 Index, was down 4.3%, versus a 1.7% decline for the S&P 500 Index. Operating EPS for the sector is expected to rise to a healthy 15% in 2005. Tech stocks recently traded at P/E-to-growth-rate levels comparable to those of the S&P 500. While the markets were recently favoring consumer discretionary and tech stocks, Standard & Poor's believes that rate increases and higher oil prices will continue to put pressure on the tech sector in the near term.

Below is a list of tech ETFs based on three-year annualized returns.

Standard & Poor's Review: Information Technology ETFs

Tech ETF

May Returns (%)

YTD Return Through 5/31/05 (%)

Three-Year Annualized Returns Through 5/31/05 (%)

Three-Year Standard Deviation Through 5/31/05 (%)

Expense Ratio (%)

iShares Goldman Sachs Networking Index Fund (IGN)

+11.9

-9.5

+11.2

47.1

0.50

iShares Goldman Sachs Software Index Fund (IGV)

+9.4

-7.0

+9.9

28.0

0.50

Nasdaq 100 Trust (QQQQ)

+8.6

-4.8

+8.2

24.2

0.20

streetTRACKS Morgan Stanley Technology High Tech 35 (MTK)

+9.7

-6.0

+7.3

30.7

0.52

iShares Dow Jones U.S. Technology (IYW)

+8.9

-3.6

+4.6

28.5

0.60

S&P Select Technology SPDR Fund (XLK)

+6.8

-4.5

+4.4

26.8

0.26

iShares S&P Global Technology Sector Index (IXN)

+7.1

-4.2

+4.3

26.9

0.65

iShares Goldman Sachs Technology Index (IGM)

+9.0

-5.7

+4.2

29.2

0.50

iShares Goldman Sachs Smiconductor Index (IGW)

+11.5

-0.7

-3.6

41.9

0.50

Vanguard Information Technology VIPERs (VGT)

+8.3

-4.4

N/A

N/A

0.28

SOURCE: Standard & Poor's. Total returns are in U.S. dollars and include reinvested dividends. Data as of 5/31/05.

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