ETF Expert: Software ETFs Programmed for Industry’s Revival

Average revenue growth in the software field was 15% last year, and most industry players expect even stronger growth this year.

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Even with a series of weaker-than-expected reports raising concern that the U.S. economy is sliding back into recession, there are several economic outposts located far enough from the housing sector to be generating growth on their own. One such region is information technology.

Information technology is one of just two sectors that Standard & Poor’s Equity Strategy recommends investors overweight in their portfolios (the other is consumer staples), due to the start of a new replacement cycle for personal computers, healthy balance sheets, strong exposure to growing emerging markets, and cost cuts implemented during the recession.

S&P Equity Research believes IT companies will report a 49% gain in operating income per share during 2010.

Also, shares of many IT companies are still trading near their lowest price in the past decade. Indeed, valuations appear so compelling that several IT companies have started to make acquisitions recently; Dell and Hewlett-Packard even got into a bidding war over data-storage company 3PAR.

While tech companies of all types are feeling the urge to merge, one tech industry that is enjoying remarkably strong health is the software industry, which is benefitting from stronger corporate spending on software this year compared to 2009.

Small and mid-sized software companies have increased profits “dramatically over the last year,” according to a September 2010 study by the Software & Information Industry Association. Average revenue rose by 15% in 2009 compared with 2008, and 75% of respondents expect even stronger growth in 2010.

“This segment of the software industry has effectively weathered the recession and stands poised for substantial growth in the year ahead,” the study said.

There are three exchange-traded funds, or ETFs, that let investors target the U.S. software industry.

iShares’ ETF

By far, the largest and most actively traded is the iShares S&P North American Technology-Software Index Fund (IGV), which has $281 million in assets and trades about 100,000 shares a day. This fund was formerly known as the iShares Goldman Sachs Software Index Fund, until the index was sold by Goldman to Standard & Poor’s in 2007.

The iShares software ETF was launched in July 2001 amid the meltdown in Internet stocks, and its returns since then have been fairly volatile: It’s had three calendar year losses – in 2002, 2005, and 2008 – and two years of gains topping 45%.

Since inception, IGV has returned an average annual loss of about 1.4%. The fund tracks a modified market-capitalization weighted index, with the largest of its 51 holdings limited to 8.5% of assets and holdings equal to 5% or more of the fund limited to 46% of the fund.

As of early September, the fund’s largest holding was Adobe Systems at 8% of assets. Other holdings accounting for more than 5% of assets include Microsoft, Intuit, Oracle, Salesforce.com, Citrix Systems and Symantec. 

The other software ETFs are much smaller and less actively traded.

PowerShares, HOLDRs

The PowerShares Dynamic Software Fund (PSJ) and the Merrill Lynch Software HOLDRS (SWH) each have about $60 million in assets and trade about 25,000 shares a day. Otherwise, the two offer very different approaches for investors.

For those who want a concentrated portfolio of large software stocks at the least cost possible, there’s the Software HOLDRS, one of 17 HOLDR funds launched in 2000 at the height of the Internet boom.

While they are often lumped together with ETFs, they are really exchange-traded trusts that represent an undivided interest in a fixed basket of stocks, somewhat like a closed-end fund. HOLDRs can be purchased in lots of 100 and can be exchanged by individual investors for a proportionate share of the underlying stocks. There is no management fee, and the holdings do not change, though their weightings do, owing to differences in relative performance over time. The Software HOLDR has just 13 holdings; SAP and Microsoft each account for more than 18% of assets. Other large holdings include Oracle and Intuit.

By contrast, the PowerShares Dynamic Software Portfolio owns a portfolio that’s rebalanced quarterly using its “Dynamic” selection criteria, which screens stocks according to a variety of “fundamental growth, stock valuation, investment timeliness and risk factors,” according to PowerShares.

The fund started business in June 2005, and as of June 30, 2010 has returned about 6% annually since inception.

It is far less concentrated than the Software HOLDR fund, with 31 holdings, none of which exceed 6% of assets. As of September 7, the top three holdings were Oracle, VMware, and Adobe Systems.

 

 

 

 

 

 

 

 

 

S&P Senior Financial Writer Vaughan Scully can be reached at Vaughan_scully@standardandpoors.com. Send him your ideas for ETF story topics.

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