The Best Technology ETFs Aren’t the Most Obvious Ones

What defines a “technology stock”?

For investors in individual companies, sector designations don’t matter. But for those who use exchange-traded funds to make sector bets, it can matter quite a bit.

There are no fewer than 12 broad-based technology ETFs, and this doesn’t count PowerShares QQQ (QQQ), which (correctly or otherwise) many people use to gain tech-sector exposure. But among these various funds, the idea of what constitutes “technology” can vary substantially.

The differences stem, in part, from the treatment of companies that use technology as a platform as opposed to engaging in the business of creating technology. This difference is most clearly visible with (AMZN), which enables shopping via the Internet, but which at its core is a retailer. MasterCard (MA) and Visa (V) — which utilize technology but are essentially transaction processing companies — also are heavily represented in tech ETFs. Facebook (FB) and eBay (EBAY) also are among those that can be considered platform companies rather than technology stocks, per se.

In addition, various IT services companies that populate tech portfolios — think Accenture (ACN), Automatic Data Processing (ADP) and the like — aren’t the type of creators or innovators that would typically characterize what most investors think of as “technology.”

These nuances make it critical to take a deep look into a technology fund’s portfolio to see how much of what they hold is pure technology, and how much consists of telecommunications stocks — see the Technology SPDR (XLK), which counts AT&T (T) and Verizon (VZ) among its top holdings — or “platform companies” such as those mentioned above.

The answer, in fact, varies widely among the top funds.

The waters become even muddier when it comes to QQQ, which tracks the “tech-heavy” Nasdaq-100 Index but which also has major weightings in consumer discretionary (19.8%), healthcare (13.6%), and other non-technology sectors (8.3%). In fact, as I’ve discussed here, QQQ has proven highly inefficient not just for tracking technology, but also in its role as a “high-beta” option in rising markets.

The table below provides a sense of how much QQQ and the six largest broad-based tech ETFs provide exposure to pure-play technology stocks:

PowerShares QQQ Trust QQQ 52.0% 10.7%
Technology SPDR XLK 74.6% 8.0%
Vanguard Information Technology ETF VGT 86.8% 8.4%
iShares U.S. Technology ETF IYW 97.6% 7.6%
iShares North American Tech ETF IGM 84.1% 8.1%
Guggenheim S&P 500 Equal Weight Technology ETF RYT 85.2% 8.7%
SPDR Morgan Stanley Technology ETF
MTK 82.6% 7.1%

The key takeaway from the discussion above is that technology ETFs can (and do) have substantial portions of their portfolios in areas other than pure-play tech, meaning investors aren’t necessarily going to get what they expect from these funds in the short-term.

One solution is to narrow the focus to iShares Dow Jones US Technology Sector Index Fund (IYW), which — as the table above demonstrates — offers the cleanest exposure to the sector among the largest ETFs. It largely avoids not just the IT services companies, but it also steers clear of platform companies whose performance might be affected by the strength of the retail sector and business trends not directly related to tech.

As a result, IYW should therefore be the focus of those who want to invest in tech without the “pollution” caused by non-tech exposure.

But Weightings Matter, Too

Technology ETFs don’t just vary in terms of what they hold, but also the size of the holdings. For instance, a fund’s success — or lack of it — has largely been dependent on its approach to Apple (AAPL) in the past few years. The stock was weighted at more than 20% in IYW, XLK and VGT at its peak last year. This large weighting helped these funds rocket to new highs when the stock was surging, but lag once it hit the skids.

However, now, with Apple now making up a smaller portion of the typical tech portfolio than it did a year ago — weightings in other mega-caps such as Microsoft (MSFT) and Google (GOOG) are playing a larger role in performance.

One way to circumvent this issue — and prevent a handful of stocks from making or breaking your investment in technology — is to look at the Guggenheim S&P 500 Equal Weight Technology ETF (RYT). Although only the 11th-largest fund in the category with just $234 million in assets, RYT also has been one of the top performers over time. On both a three- and five-year basis, in fact, it has been the top fund among large, broad-based tech ETFs.

RYT isn’t the pure play IYW is, but it enables investors to make a play on the tech business without having their fortunes determined — in large part — by whether or not iPad sales beat expectations.

The success of the equal-weight approach has been well documented, but it can add the most value in technology, where the weightings are skewed most dramatically toward the largest companies. For a long-term investor weighing the options among tech ETFs, RYT deserves a spot at the top of the list.

The Bottom Line

The large divergences among individual technology portfolios — both in holdings and in weightings — can translate to short-term results that might deviate from expectations, but these issues can be alleviated by the approaches employed by IYW and RYT.

Look past the largest funds in the category to give these lesser-known ETFs a closer look.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

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