Poisonous Apple? 3 Broad Technology ETFs With Limited Or No Exposure To The Largest Tech Stock

by: Alan Brochstein, CFA

How is your technology ETF doing so far this year? My guess is that you are likely disappointed if you have tilted your portfolio through ETFs toward technology. While the S&P 500 has jumped almost 4.2% to start the year, the technology component, according to Standard & Poor's, has increased just 1.85%, the tird-worst sector of the 10 that comprise the index.

It's rather interesting to dive in, as one might automatically conclude incorrectly that technology stocks just aren't performing well. Through 1/18, 38 of the 71 names that make up the sector (54%) have increased more than the 4.19% rise in the S&P 500. If you own a technology stock, you are more likely than not doing better than owning a non-technology stock on average. This means that the other 46% must be performing really badly then, right? Not exactly, as only 11 of the other 33 names have declined in price.

So, what is going on? To answer that question, one must understand the fatal flaw of indexes based on market capitalization. The S&P 500 gives more weight to bigger stocks, forcing passive investors to become momentum players by owning larger percentages of underlying stocks as they appreciate in value and smaller amounts as they fall.

In the case of technology, one company dominates the sector: Apple (NASDAQ:AAPL). So far this year, it has declined 6%, the absolute worst performance of the 71 technology stocks in the index. According to the S&P 500, the index is valued today at about $13.27 trillion, with the tech sector, the largest, worth about $2.47 trillion (18.6%). AAPL is the largest single stock, and its $470 billion market cap represents about 3.5% of the S&P 500 but a massive 19% of the technology sector. Based on beginning-of-the-year weights, the 6% absolute decline and 10% relative decline in the stock has knocked off about 2% from the sector return.

If you are using ETFs to invest in technology, the chances are that you are investing in the SPDR Technology (NYSEARCA:XLK), which is designed to replicate the performance of the S&P 500 technology and telecommunications stocks (market-cap weighted). Here, AAPL represents about 17% currently of the ETF, as I illustrated above but adjusted for the additional stocks. Perhaps you use the PowerShares QQQ (NASDAQ:QQQ), which is designed to track the NASDAQ 100. Here, AAPL represents about 15% according to PowerShares. QQQ is lagging the market in 2013, up just 3%.

There are some other large, diversified technology ETFs, and they are all suffering from their exposure to AAPL. According to one of my favorite analytical databases for ETF research, ETF Database (what a great name), the three largest pure technology ETFs, which are among the almost 50 that the service tracks for the sector, are:

  • XLK, with $8.7 billion in assets and up 1.87% YTD
  • Vanguard IT Index Fund (VTX), with $2.7 billion in assets and up 2.4% YTD
  • iShares DJ Tech (NYSEARCA:IYW), with $1.6 billion in assets and up 1.75% YTD

I don't have a strong view on AAPL, and ETF investors shouldn't need to have one either. Otherwise, they would likely choose to invest directly. It's possible to get broad exposure to the technology sector without taking such a concentrated bet on a single company, and here are three ideas:

  1. Guggenheim Equal Weighted S&P 500 Technology (NYSEARCA:RYT)
  2. PowerShares S&P 500 Small-Cap Technology (NASDAQ:PSCT)
  3. iShares S&P GSTI Tech (NYSEARCA:IGM)

RYT has the benefit of its simplicity, as it includes the same 71 stocks (no telecoms) but weights them equally. AAPL then represents the same approximate 1.5% as the smallest tech stock included in the S&P 500. So, what's wrong? It's small, with less than $100mm in assets, which means less liquidity and higher expenses. The ETF is up 5.19% in 2013, and here is a link to more information.

PSCT is a different kind of strategy, as there is zero overlap with XLK, as the stocks it holds are all from the S&P 600 Small-Cap index. I have shared my positive views on small-caps on several occasions over the past few months, suggesting that they are likely to perform well relative to large-caps. I am not so sure that one should consider this ETF as one's sole exposure, but it might make sense to incorporate it into an overall strategy of technology investments. Here again, the major negative is the small size of the ETF, which is up 5.38% YTD. Here is a link to more info.

Finally, IGM has significant AAPL exposure, but it's a lot less at 8%. What I like about this ETF (here is a link to more info) is that it is reasonably large at $472mm (with expenses of 0.48%). This is based on the "S&P North American Technology Index," one with which I had no familiarity until researching it. According to S&P, it is based on market-cap but capped at a maximum of 8.5% (rebalanced twice a year). Thus, AAPL is currently close to 8%.

Before I conclude, I want to share a perspective of how these ETFs have performed since the end of Q3 as well as longer time-frames:

AAPL had already peaked in mid-September. Since the end of Q3, it has declined about 25%, contributing to a divergence between XLK (down 5%) and RYT (up 6%). IGM, with its limited exposure, has done better than XLK, while PSCT, with no exposure to AAPL, has performed the best.

Here we see better the whole round-trip of AAPL over the past year. At its peak in September, we can see the 10% impact it had on XLK (which was up 20% after a 65% rally in AAPL) compared to RYT (up about 10% at the time). Since then, RYT has advanced, while XLK has contracted.

In this chart, which dates back to the launch of PSCT, we, perhaps not surprisingly, see that PSCT has led the way - small-caps have outperformed over this time-frame. PSCT is near its all-time high set in 2011.

The perspective back to late 2006 dates to the debut of RYT. While RYT has lagged XLK since inception, note that it seems to have a bullish formation in that it is testing its all-time highs for now the third time.

I share this final chart because it illustrates that IGM may be a viable alternative for XLK. Note that it dates back to 2001 (XLK dates back to 1998), so it has a substantial track record. Second, it's interesting that it is actually beating XLK rather significantly despite the big impact AAPL had on XLK. It could be that capping the exposure at 8.5% keeps the ETF from succumbing to the negative outcome of staying with momentum for too long.

ETF investors who are trying to tilt their portfolios towards technology may be making a big bet on AAPL that they may or may not wish to make. I have demonstrated how the poor start to 2013 (as well as Q4-2012) has hurt some of the biggest and best-known tech ETFs and shared a few alternatives for those who would like to avoid taking on such high exposure to a single stock. The flip-side, and one that resonates with me, is that one can more easily see why XLK has performed so poorly recently and make a more informed investment decision understanding the impact of AAPL.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I include XLK among the holdings in my Sector Selector ETF model