[Editor’s Note: This article was originally published on July 26, 2018, and was updated on July 30, 2019, with the most recent information.]
Investors looking for industry-level attribution for the technology sector’s strength should not look past software. Simply put, among technology exchange traded funds (ETFs) this year, software ETFs are represent sources of strength.
This is one nugget cementing the strength of software ETFs: the S&P North American Technology-Software Index as measured by the iShares Expanded Tech-Software Sector ETF (BATS:IGV) is up 32% year-to-date while the tech-heavy Nasdaq-100 Index is up 25.8%. However, investors will pay up for the privilege of owning software stocks and ETFs.
“As a group, software companies enter the second-quarter earnings period trading at record valuations,” according to Barron’s. “Macquarie Capital analyst Sarah Hindlian finds that the average software stock is trading for a record 7.1 times next fiscal year’s projected revenues. The one-year average valuation on that basis is 5.6 times, she reports. The five-year average is 4.4 times and the 10-year average is 3.9.”
Adding to the bull thesis for software ETFs are robust revenue expectations across a wide array of software platforms, including cloud, cybersecurity, customer relationship management (CRM), internet applications and video games.
Investors can participate in this corner of the technology sector with the following software ETFs.
iShares North American Tech-Software ETF (IGV)
Expense Ratio: 0.47% per year, or $47 on a $10,000 investment.
The iShares North American Tech-Software ETF is one of the largest, oldest and most traditional software ETFs. Home to over $2.8 billion in assets under management, IGV tracks the aforementioned S&P North American Technology-Software Index, cap-weighted software gauge dominated by the industry’s largest players.
Just four stocks — Salesforce.com (NYSE:CRM), Microsoft (NASDAQ:MSFT), Adobe Systems (NASDAQ:ADBE) and Oracle (NYSE:ORCL) — combine for over a third of this software ETF’s weight. Those are the breaks with industry and sector funds that are weighted by market capitalization, but investors probably are not complaining about IGV’s 32% year-to-date gain.
Assuming software stocks maintain their leadership perch in the technology sector, this will be the fourth year in the past five that IGV has outpaced the broader XLK.
The potential quibble with IGV is that its price-to-earnings ratio is over 40, implying a significant premium relative to broader technology funds.
SPDR S&P Software & Services ETF (XSW)
Expense Ratio: 0.35%
For investors looking for a software ETF that is not heavily dependent on the industry’s large- and mega-cap names, the SPDR S&P Software & Services ETF (NYSEARCA:XSW) is a suitable alternative. This software ETF is an equal-weight fund and none of its 159 holdings commands a weight north of 1%.
XSW’s top 10 holdings combine for just 9.2% of the fund’s weight. This software ETF is up 35% year-to-date, indicating its tilt toward smaller software stocks is rewarding investors. While it is not driven by the industry’s largest names, its P/E ratio of 25 is more attractive than IGV’s.
The XSW ETF also boasts gains of 19% in the last year, 25% in the past three years and 17% in the past five years.
Invesco Dynamic Software ETF (PSJ)
Expense Ratio: 0.63%
The Invesco Dynamic Software ETF (NYSEARCA:PSJ) is another example of a software ETF with an alternative weighting methodology. PSJ follows the Dynamic Software Intellidex Index.
That index “is designed to provide capital appreciation by thoroughly evaluating companies based on a variety of investment merit criteria, including: price momentum, earnings momentum, quality, management action, and value,” according to Invesco.
Implementation of those factors results in a lineup of just 30 stocks, a far smaller roster than IGV of XSW have. PSJ is up over 40% this year, due in part to contributions from the likes of Microsoft and Salesforce. Said another way, PSJ is not just one of the best software ETFs, but one of the best tech industry ETFs of any stripe in 2019.
While this software ETF allocates over 81% of its weight to growth stocks, its annualized volatility has only been slightly higher than the Nasdaq-100 Index’s over the past three years, a period in which PSJ has trounced that benchmark.
ETFMG Prime Cyber Security ETF (HACK)
Expense Ratio: 0.6%
HACK tracks the Prime Cyber Defense Index, which is “comprised of companies that offer hardware, software, consulting and services to defend against cybercrime,” according to the issuer.
Over 62% of HACK’s holdings are software companies, split among the systems and internet software industries. HACK has the potential to be a dominant name over the long term.
Just three years ago, cybersecurity attacks resulted in damages of $3 trillion, but that number could jump to $6 trillion by 2021, meaning companies and governments will be spending in a big way on warding off cyber threats. HACK and cybersecurity stocks were pinched by the China trade conflict as highlighted by a big May-June decline that has the fund up “just” 23% this year.
ETFMG Video Game Tech ETF (GAMR)
Expense Ratio: 0.74%
Hardware is part of the conversation when discussing video game investing, but the ETFMG Video Game Tech ETF (NYSEARCA:GAMR) is a credible software ETF, as it has significant holding overlap with more traditional software ETFs. In fact, some of GAMR’s top 10 holdings, including Take-Two (NASDAQ:TTWO), are top 10 holdings in other such funds.
Past performance is never a guarantee of future returns, but it cannot be ignored that GAMR has more than doubled over the past three years. Plus, this software ETF has a plethora compelling future catalysts that could signal its run still has momentum. Digitalized gaming is one of those catalysts.
“The percentage of digitally downloaded video games rose from 31% in 2010 to 74% in 2016,” according to GAMR’s issuer. “This is expected to climb to nearly 93% by 2021.”
GAMR looks more attractive today than when we first ran this piece a few months by virtue of an almost 18% decline off its 52-week high. Investors interested in this fund may want to wait for it snap out of its recent funk.
Global X Future Analytics Tech ETF (AIQ)
Expense Ratio: 0.68%
The Global X Future Analytics Tech ETF (NASDAQ:AIQ) is one of the newest additions to the software ETF fray, having debuted in 2018. AIQ follows the Indxx Artificial Intelligence & Big Data Index.
This is not a pure software fund, but there are myriad intersections between the artificial intelligence and big data themes and software. Several of AIQ’s top 10 holdings, including Microsoft and Adobe, reside in more pure, traditional software ETFs. Ovearll, more than 51% of AIQ’s 83 holdings are classified as software companies.
AIQ is a little over a year old and is on a torrid pace this year with a gain of 32%.
First Trust Cloud Computing ETF (SKYY)
Expense Ratio: 0.6%
It is just one example, but one reason why shares of Microsoft are up almost 40% this year is the cloud computing boom. Cloud computing is also powering another company you’ve probably heard of — Amazon (NASDAQ:AMZN). For the investors who do not want to stock pick among cloud names, the First Trust Cloud Computing ETF (NASDAQ:SKYY) is the idea to consider.
SKYY is not a dedicated software ETF, but if you combine the fund’s exposure to traditional and internet software purveyors, the figure is north of 54%. Like some of the other funds mentioned here, SKYY has significant long-term potential.
“The widespread adoption of cloud-based software is shifting the dynamics of the software industry, spreading the reach of enterprise-class applications to smaller businesse and reducing the costs involved in creating, selling, and supporting applicatios,” according to Barron’s.
The worldwide public cloud services market is projected to grow 17.5% in 2019, and according to Sid Nag, research vice president at Gartner, “Through 2022, Gartner projects the market size and growth of the cloud services industry at nearly three time the growth of overall IT services.”
Todd Shriber does not own any of the aforementioned securities.