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The ETF Approach to Tech Investing

By Angelina Dance While some mutual-fund managers might have scaled back on the volatile technology sector, other investors seek to better control or increase their exposure to the sector -- and they have a new tool at their disposal, namely exchange-traded funds.

Many ETFs not only track popular technology indexes and even subindexes but are also 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.

PROFITABLE DEVICES. Scott Kessler, Standard & Poor's director information technology equity research, takes issue with those who shy away from technology stocks on the basis of poor fundamentals. In fact, he finds valuations reasonable and fundamentals improving enough to revive interest in the sector again. In May, technology stocks outperformed the 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 tech, data storage among them. Demand is being fueled by regulations mandating the backup of information, as well as by the popularity of portable devices such as Apple Computer's (AAPL) iPod, digital cameras, and cell phones. EMC (EMC), the leading supplier of enterprise data-storage systems and software, reported that revenues soared 32% in 2004.

The Internet advertising area also shows promise. Revenues in the segment have grown significantly as such companies as Yahoo! (YHOO) and Google (GOOG) connect advertisers with online users through keyword searches and other targeted methods.

LARGE-CAP PLUSES. 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 and fraud. Companies in this segment include McAfee (MFE) and Check Point Software (CHKP). Meanwhile, growing trends in telecommuting and online meetings have spurred demand for remote functionality and the need for solid Web access infrastructure.

Overall, Kessler emphasizes stocks of quality, large-cap technology companies because they often have better brands, more diversified business models, and stronger balance sheets. Many of them will be less affected than their smaller-cap counterparts when they begin expensing stock options in 2006.

Among 10 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. It rose 11.2% for the period, vs. 5.6% for the S&P 500 index and 5.2% for the S&P 500 Information Technology index.

TOP HOLDINGS. However, this ETF is not for the faint of heart. It carries extreme volatility, 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 the Goldman Sachs Networking Index Fund's top holdings at the end of May were Corning (GLW), Qualcomm (QCOM), and Research In Motion (RIMM). In addition, the top 10 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 10 ETFs surveyed in terms of absolute performance.

PLAYING ON THEMES. Still, this offering's narrow focus on semiconductor stocks makes it extremely volatile. Top holdings include Intel (INTC), Texas Instruments (TXN), and Motorola (MOT). More than 90% of the fund is invested in semiconductors. As of the end of May, the top 10 positions made up 58.8% of the portfolio. In short, considering the high volatility, narrowly focused ETFs like Goldman Sachs Networking Index and Goldman Sachs Semiconductor Index are more suitable for tactical market decisions 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 nonfinancial companies listed on the Nasdaq; the S&P Select Technology SPDR Fund (XLK), which holds the large, blue-chip tech shares in the S&P 500; and iShares Dow Jones US Technology (IYW), which tracks the IT stocks in the Dow Jones U.S. Total Market Index -- offer more exposure to technology's subsectors. These funds also make it easier to use themes like data storage, Internet advertising, and online security, or to focus on blue-chip names. Although they still carry a lot of volatility, their ups and downs are not as extreme as more narrowly focused ETFs that track mainly one specific industry.

However, many differences exist among the broader-based tech ETFs. The Nasdaq 100 Trust, for instance, includes both domestic and international holdings, as well as stocks of some emerging-technology companies and some nontech sectors, while the S&P Select Technology SPDR Fund holds 90 U.S.-based large-cap tech issues without much exposure to emerging-technology outfits.

BRAND-NEW FUNDS. 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 more than 55% of its assets in its top 10 positions. In contrast, the streetTRACKS Morgan Stanley Technology High Tech 35 ETF has only 36 holdings. It tracks the Morgan Stanley Technology Index, which comprises shares of U.S. companies chosen from 11 tech subsectors.

Last week, three new tech ETFs entered the fray. In a twist on ETF investing, PowerShares Capital Management 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 derive from 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.

MANAGING VOLATILITY. PowerShares' new tech ETFs offerings based on this 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 experienced twice the volatility of 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.

Here's a list of tech ETFs ranked by three-year annualized returns.

Information Technology ETFs

Tech ETF

YTD Return through 5/31/05 (%)

3-Year Annualized Return through 5/31/05 (%)

3-Year Standard Deviation (%)

Expense Ratio (%)

iShares Goldman Sachs Networking Index Fund (IGN)





iShares Goldman Sachs Software Index Fund (IGV)





Nasdaq 100 Trust (QQQQ)





streetTRACKS Morgan Stanley Technology High Tech 35 (MTK)





iShares Dow Jones U.S. Technology (IYW)





S&P Select Technology SPDR Fund (XLK)





iShares S&P Global Technology Sector Index (IXN)





iShares Goldman Sachs Technology Index (IGM)





iShares Goldman Sachs Semiconductor Index (IGW)





Vanguard Information Technology VIPERs (VGT)





Dance is a fund analyst for Standard & Poor's Fund Advisor

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