Exchange-traded funds. or ETFs, can be an excellent way to get immediate and diversified exposure to a sector. For instance, every trading day numerous market participants buy and sell the Technology Select Sector SPDR Fund (NYSEARCA:XLK). Indeed, for years the XLK ETF has been among the most popular ways to gain exposure to the tech sector.
Similar to a mutual fund, an ETF can allow investors to take a small stake in many different companies, all within the same market sector, at the same time. Thus, while the technology sector can be volatile, the XLK ETF can reduce investors’ exposure to volatility through diversification.
On the other hand, XLK might not be the best choice for everyone. In fact, one particular ETF might appeal to diversification-seeking investors more than XLK does. As InvestorPlace contributor Aaron Levitt so eloquently put it, “as awesome as the XLK is as a core tech fund, it isn’t the only fish in the sea.”
A Closer Look at the XLK ETF
Now, let’s start with a snapshot of the basic facts about the XLK ETF. It offers quarterly distributions, it’s optionable (meaning that there are options that can be traded on XLK) and margin traders can short-sell XLK if their broker allows it.
SSGA FM is the fund’s investment adviser, and XLK’s annual fund-operating expenses are a super-low 0.13%. So, if you’re not in the mood to forward a large portion of your investment returns to fund managers, XLK is quite frugal in this regard.
The stated investment objective of the XLK fund is “to provide investment results that, before expenses, correspond generally to the price and yield performance of publicly traded equity securities of companies in the Technology Select Sector Index.” But what are those companies?
Less Cost, Less Diversification
Here’s where it gets interesting, and perhaps a bit problematic. If you’re thinking that the XLK ETF covers a very large swath of the tech sector, you might be in for a surprise.
XLK includes 71 companies in its holdings, and that might be a shock to folks who were expecting that number to be bigger. In contrast, the PowerShares QQQ Trust (NASDAQ:QQQ) ETF provides exposure to 100 tech-focused names.
Therefore, you’ll be getting more diversification from QQQ than with XLK in terms of the number of companies represented. Be advised, though, that QQQ’s expense ratio is 0.2%. So, you’ll have to pay a slightly higher price for enhanced diversification.
And there’s another issue when it comes to diversification. Microsoft (NASDAQ:MSFT) has a weighting of 22.2% in XLK’s underlying index. Plus, Apple (NASDAQ:AAPL) has a weighting of 21.5%. That’s a total weighting of 43.7% in just two companies.
What’s Expected vs. What’s Delivered
Given the foregoing stats, XLK might be too lopsided for investors seeking a balanced mix between a wide array of tech names. Meanwhile, as of July 12, 2020, QQQ gave Microsoft a 11.6% weighting and Apple a 11.9% weighting. This, then, appears to represent a more balanced allocation strategy.
Finally, one must consider whether XLK delivers the expected results vis-a-vis the movements of tech stocks generally. It’s only one trading day, but the price action witnessed on July 10 provides an instructive snapshot of how XLK might perform on a typical day.
On that day, the Nasdaq composite gained 0.66%. That’s a pretty good day for the Nasdaq, so XLK shareholders have every reason to expect something reasonably close to this performance percentagewise.
Yet, XLK closed in the red on that day. It was only a 0.03% loss, but that could nonetheless cause consternation among XLK’s investors. The previously discussed lopsided allocation structure might, in part, be to blame for this apparent discrepancy.
QQQ, meanwhile, gained 0.68% that day. That’s quite close to the Nasdaq’s gain and it illustrates how QQQ’s diversification may, in some instances at least, produce results more in line with what many tech-focused investors would expect.
The Bottom Line
The XLK ETF isn’t bad, though it might not provide investors with the breadth of tech-sector diversification they were expecting. For a more balanced mix of well-known tech names, investors might consider QQQ as a reasonable alternative.
As of this writing, David Moadel did not hold a position in any of the aforementioned securities.