Our Favorite Tech ETF: A Low-Cost Way to Tap Into Mobile-Computing Growth

Morningstar

Morningstar's Take
As the U.S. stock market has continued its climb in 2013, investors in large- and mid-cap U.S. technology stocks might wonder whether there's much more runway left. Certain technology subsectors, such as Internet and semiconductors, have done very well, while some tech players, such as Apple (AAPL) and IBM (IBM), have underperformed both the sector and the broader market.

The bull case for the U.S. technology sector revolves around companies that have lagged the broader market but are expected to benefit nicely from continued strong growth in mobile computing, such as Apple, Qualcomm (QCOM), and Broadcom (BRCM). These firms all possess structural competitive advantages, economic moats, reasonable valuations, and exposure to mobile computing. Further gains in the tech sector likely will come from companies benefiting from mobile computing, such as these firms.

For investors interested in technology, we recommend Vanguard Information Technology ETF (VGT). The fund offers an inexpensive way to tap into some of the best parts of the U.S. tech sector, such as its continual growth, its "moaty" aspects, and its growing income potential, while at the same time providing a certain stability for investors.

As a sector-specific exchange-traded fund, VGT should be viewed as a tactical investment, suitable only for the satellite portion of a diversified portfolio. Over the past five years, VGT had a volatility of return of 20.7% compared with 18.0% for the S&P 500 Index.

VGT holds mostly large, well-established technology firms and holds a large number of stocks (414). It does have a top-heavy aspect to it, with its top-10 holdings making up a significant 53.5% of the portfolio. At the same time, VGT has a very high-quality portfolio--wide-moat and narrow-moat firms account for about 51.5% and 31% of the portfolio, respectively, meaning that Morningstar's equity analysts believe that more than 82% of VGT's assets are invested in firms with sustainable competitive advantages.

The heavyweight technology ETF is Technology Select Sector SPDR (XLK). Vanguard Information Technology ETF differs from XLK in that it holds a much broader portfolio than the SPDR's 73-name portfolio. Plus, VGT devotes more than 22% of its assets to small- and mid-cap tech companies, while XLK invests just 9% of its assets in small- and mid-cap firms. However, the two ETFs' performances are very highly correlated (99%), so the practical effect of these portfolio differences isn't great. And a quick look at the two ETFs over the past six years shows that the two funds have performed almost identically. Given that VGT's 0.14% price tag is slightly lower than the XLK's 0.18%, this ETF is our favorite technology-sector ETF.

Fundamental View
The single largest dynamic affecting the U.S. technology sector right now is the ongoing shift toward mobile computing and the growth in cloud computing. Mobile and cloud computing are truly a disruptive force in the tech sector. As users shift to mobile devices, PC sales continue to fall. Morningstar's equity analysts expect global PC shipments to drop 8% this year, with the multiyear declines in developed markets now being accompanied by moderate declines in emerging markets. Despite declines in PC sales, the total number of devices sold actually is expected to rise meaningfully in the years to come, as consumers and businesses adapt to smartphones and tablets. In fact, our analysts project that in 2017, some 2.6 billion-plus computing devices will ship--more than twice the total number of devices that shipped in 2012.

Across the U.S. tech sector, firms have been reshaping their portfolios for this ongoing transition. Microsoft (MSFT) recently acquired Nokia's (NOK) handset business and has developed the Windows Phone operating system, while Intel (INTC) has been investing heavily in producing microprocessors optimized for mobile devices. Apple long has been at the head of the pack with its iPhone and iPad, continually gaining share from struggling competitors such as HTC, BlackBerry (BBRY), and Nokia. And Google (GOOG) long has had a dominant position in Internet search but has been very successful at aggressively investing in its Android operating system for smartphones and tablets and providing it free of any license fees, which means that having Google software on the device helps to ensure that when users search, they use Google.

Even enterprise hardware suppliers have gotten into the act. Enterprise suppliers such as Hewlett-Packard (HPQ) and EMC (EMC) have struggled as government budgets remain tight, enterprise IT managers are holding the line on their spending, and the hardware components used to support IT operations have become more and more commoditylike. However, many enterprise players have been reshaping their businesses as well, whether by Cisco Systems (CSCO) acquiring a network security vendor, HP tightening up its operations and improving its balance sheet, or EMC recently forming a cloud computing platform joint venture.

Broadly, we have confidence in tech firms' positioning for growth in the medium term. Tech stocks generally are procyclical in their performance, and as the economy strengthens in the short and medium term, tech firms in general should do well. The Gartner Group forecasts tech spending to grow 4.1% in 2013. As large tech players manage and reshape their businesses to adapt to secular declines in PC demand, we expect that they will continue to find ways to benefit from smartphone and tablet growth. To be sure, not all technology players will be winners in a world dominated by mobile computing and cloud computing. For instance, we view cloud computing as a moderate threat to all IT infrastructure suppliers, as cloud service providers are technically savvy customers. That means that as enterprises migrate their infrastructure to these service providers, infrastructure suppliers' pricing power likely will decrease.

Apple makes up 13% of VGT's assets, making it far and away this fund's largest holding. Apple has had a turbulent year as investors have questioned both the company's willingness to keep new iPhones and iPads at premium price points both in developed and emerging markets and the company's overall ability to grow in emerging markets. Morningstar's analysts view Apple as a firm that stands to benefit from huge growth in the smartphone and tablet markets even if it only grows at the market rate. Our analysts also believe that Apple's software and services carry with them modest switching costs and the ability to build a loyal user base of customers, all while positioning Apple as a key differentiator relative to Google's Android platform. We expect Apple to remain a leader in the premium smartphone and tablet markets for years to come.

Portfolio Construction
VGT tracks the cap-weighted MSCI US Investable Market Information Technology 25/50 Index, which includes the technology companies of the MSCI US Investable Market Index (a broad, cap-weighted index representing approximately 98% of the U.S. market capitalization). VGT contains 414 stocks. The subsector weights are spread pretty evenly across the technology space, with no one subsector dominating this fund. The largest subsector weightings are software (20%), computers and peripherals (19%), Internet software and services (16%), semiconductors (10%), and IT services (9%).

Fees
This ETF carries a 0.14% expense ratio, which is lower than all other technology-sector ETFs. The fund's estimated holding cost is 0.14%, suggesting that this fund has tracked its index very well. Estimated holding costs are primarily composed of the expense ratio but also include transaction costs, sampling error, and share lending revenue.

Alternatives
Investors seeking technology-sector exposure can consider two other heavyweight technology ETFs: Technology Select Sector SPDR ETF and iShares U.S. Technology Sector Index (IYW), which cost 0.18% and 0.45%, respectively. Although all three funds' weightings of the top-five holdings generally are comparable, there are important differences. The SPDR is a much more concentrated portfolio (73 names) and tilts far more to large-cap names (average market cap: $103 billion), while the iShares offering falls somewhere in the middle from a diversification standpoint (142 companies) and as a result has a lower, $83 billion average market cap. There are other differences. The Vanguard fund has a large weighting (9%) in IT services firms such as Visa (V) and Accenture (ACN) and holds no telecommunication services companies such as AT&T (T) and Verizon (VZ). XLK holds IT services companies such as Visa and MasterCard (MA) and telecommunications services firms such as AT&T and Verizon. IYW, by contrast, holds no IT services companies or telecommunications services firms, thereby making it the purest-play broad technology ETF. Despite these differences, the performances of the three ETFs--VGT, XLK, and IYW--are almost perfectly correlated. Over the past five years, VGT and IYW are 100% correlated, VGT and XLK are 99% correlated, and XLK and IYW are 99% correlated.

A recently launched and very inexpensive option is Fidelity MSCI Information Technology ETF (FTEC), which charges 0.12%. However, FTEC has minimal assets and is thinly traded. FTEC tracks a slightly different index from Vanguard Information Technology ETF; FTEC tracks the MSCI USA IMI Information Technology Index, while VGT tracks the MSCI US Investable Market Information Technology 25/50 Index. Fidelity customers with a minimum balance of $2,500 can buy FTEC commission-free, although beginning Feb. 1, 2014, they are subject to a short-term trading fee by Fidelity.

Technology subsector ETFs focus on a variety of areas, including semiconductor firms (iShares PHLX SOX Semiconductor Sector Index (SOXX)), Internet companies (First Trust Dow Jones Internet Index (FDN)), and software firms (iShares North American Technology-Software Index (IGV) and PowerShares Dynamic Software (PSJ)).

The tech-heavy PowerShares QQQ (QQQ) (0.20% expense ratio) is also a suitable alternative as it has a near-perfect (99%) positive correlation with VGT, thanks to its 57% exposure to the tech sector.

Robert Goldsborough does not own shares in any of the securities mentioned above.

Disclosure: Morningstar, Inc.’s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

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