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Technology has been an exciting but volatile sector over the past three decades. In the 1980's, the mainframe computer was replaced by the personal computer and Microsoft began to dominate the operating system market with the introduction of Windows. The 1990's were the "go-go" years as the internet became of age and all "dot com" companies flourished. The bubble finally burst shortly after the beginning of the millennium and hundreds of companies went out of business. However, some of the strongest, like Amazon, not only survived but thrived and have become dominant players over the more traditional "brick and mortar" businesses. Today, technology is one of the largest segments of the economy and the products have become integral to our way of life. New products such as cloud computing, mobile phones, and social networking are changing the way we work and communicate.

Most people love new technology but has it been a good investment? This article will explore the risks and rewards associated with Technology ETFs. Among the 32 ETFs focused on Technology, I have limited my analysis to those that have at least a 3 years history and which have a daily average trading volume of at least 50,000 shares. I will look first at ETFs that cover the entire technical landscape and then narrow down to a few more specialized ETFs. The overall technology ETFs are;

  • PowerShares QQQ (NASDAQ:QQQ). This ETF is not really a pure technology play since only about 60% of the assets are devoted to technology. However, QQQ is often equated with the technology sector so I will use this ETF as a benchmark for assessing performance of other ETFs. The QQQ is comprised of the 100 largest non-financial companies listed on the NASDAQ. These top QQQ holdings read like a "who's-who" among large tech firms and include Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Google (NASDAQ:GOOG), Oracle (NYSE:ORCL), Cisco (NASDAQ:CSCO), and Intel (NASDAQ:INTC). The QQQ trades over 30 million shares per day.
  • SPDR Technology Select (NYSEARCA:XLK). This ETF is the most liquid of the exclusive technology plays, trading over 8 million shares per day. It has 80 holdings weighted by market cap. The top 5 holdings Apple , International Business Machines (NYSE:IBM), Microsoft , Google , and AT&T (NYSE:T).
  • Vanguard Information Technology (NYSEARCA:VGT). This ETF tracks the MSCI US investable Market Information Technology 25/50 Index. The 25/50 index is cap weighted but subject to the constraint that 1) no more than 25% of the index can be invested in a single company and 2) if you sum up all the companies that would each be more than 5% of the index, then the total cannot exceed 50% of the assets. This has the effect of reducing the impact of large-cap constituents to about 57% of the fund. The fund invests in 415 companies that run the gamut from small-caps to large-caps. The largest holdings are the usual large-cap companies including AAPL, IBM, MSFT, GOOG, and ORCL.
  • iShares US Technology (NYSEARCA:IYW). This ETF tracks the cap weighted Dow Jones US Technology Index that is comprised of 135 companies. The top two holdings are AAPL and MSFT, which together make up over 25% of the index. Other large holdings include GOOG, IBM, and CSCO.
  • First Trust Technology AlphaDEX (NYSEARCA:FXL). This ETF tracks the StrataQuant Technology Index, which is a proprietary algorithm that selects technology stocks from the Russell 1000. Stocks are ranked and weighted based on growth and value factors. The ETF holds 90 companies and the constituents are re-evaluated quarterly.

Software Sub-sector. Computers are now ubiquitous but they are virtually powerless without software to tell them what to do. The newest innovation is cloud computing, where your software can be obtained on-demand from the internet rather than running on your local computers. The major ETF devoted to software is:

  • iShares Software (NYSEARCA:IGV). This ETF tracks the S&P North American Technology Software Index, which has 61 cap weighted holdings including ORCL, MSFT, and Salesforce.com (NYSE:CRM). Adobe Systems (NASDAQ:ADBE), and Intuit (NASDAQ:INTU).

Semiconductor Sub-sector. The semiconductor subsector makes the chips that are a key part of most electronics. The main technology challenges in chips are how to make them smaller, use less power, and be more reliable. The major ETF in this space is:

  • iShares PHLX SOX Semiconductor (NASDAQ:SOXX). This ETF tracks the Philadelphia Stock Exchange (PHLX) Semiconductor (SOX) Index. There are 31 cap weighed stocks in the index including Applied Materials (NASDAQ:AMAT), Broadcom (NASDAQ:BRCM), Taiwan Semiconductor (NYSE:TSM), Texas Instruments (NASDAQ:TXN), and Intel .
  • Note: Another very liquid semiconductor ETF is the Market Vector Semiconductor (NYSEARCA:SMH). In the past, this was the Merrill Lynch Semiconductor HOLDR but was converted in 2011 by Market Vector to track the largest 25 semiconductor companies. I did not include it in my analysis due to its limited track record.

Networking Sub-sector. The networking subsector includes both local area networks (LANs) and Wide Area Networks (WANs) that allow computers to exchange data. The best known network is the Internet, which has revolutionized commence and information retrieval. Networks have become an indispensable part of our lives and have spawned numerous social media sites. The two ETFs in this space are:

  • iShares Networking (NYSEARCA:IGN). This ETF tracks the S&P North American Technology- Multimedia Networking Index. This index is focused on the communications hardware providers that make networking possible. The ETF is cap weighted with 27 holdings including F5 Networks (NASDAQ:FFIV), Juniper Networks (NYSE:JNPR), Motorola Solutions (NYSE:MSI), Cisco Systems, and Qualcomm (NASDAQ:QCOM).
  • First Trust Internet (NYSEARCA:FDN). This ETF tracks the cap weighted Dow Jones Internet Index. It has 41 holdings focused on large internet companies including Google , Amazon (NASDAQ:AMZN), eBay (NASDAQ:EBAY), Priceline.com (NASDAQ:PCLN), and Salesforce.com .

Nanotech Sub-sector. Nanotech is a cutting-edge technology that is attempting to build machines at atomic and molecular levels. These companies work on products ranging in size from 1 to 100 nanometers, where a nanometer is defined as one billionth of a meter. To give you some comparison, a human hair is about 100,000 nanometers and a germ is 1000 nanometers. This technology is so new that it is difficult to envision where it might lead but if some of the nanotechnology projects come to fruition, it could revolutionize the way we live (and potentially extend human lifetimes substantially). It is not an exaggeration to think that nanotechnology could someday have more impact than the internet. The ETF in this subsector is:

  • PowerShares Lux Nanotech (NYSEARCA:PXN). This ETF tracks the equal dollar weighted Lux Nanotech Index. The ETF holds 28 companies engaged in nanotechnology. These are mostly small-cap growth companies that are not household names.

To evaluate the risks and rewards of these technology ETFs, I plotted the rate of return in excess of the risk free rate (called Excess Mu on the charts) versus the volatility of each ETF. For comparison with the overall stock market, I have also included the SPY, the SPDR S&P 500 ETF. The results are shown in Figure 1 and were generated using the Smartfolio 3 program (smartfolio.com).

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Figure 1: Reward and Risk for Technology ETFs (3 years)

The Figure indicates that there has been a wide range of returns and volatilities associated with technology. The internet fund has generated the largest rate of return but at the expense of some increased volatility. Was the increased return associated with internet stocks worth the increased volatility? To answer this question, I calculated the Sharpe Ratio for each ETF.

The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. On the Figure, I also plotted a red line that represents the Sharpe Ratio of the QQQ. If an asset is above the line, it has a higher Sharpe Ratio than the QQQ. Conversely, if an asset is below the line, the reward-to-risk is worse than the QQQ.

Some interesting observations are apparent from the plot. First, the QQQ was slightly more volatile than the SPY but also provided slightly more return. Therefore, the Sharpe ratio for the QQQ and SPY are virtually the same. FDN is very near the line so if you purchased this ETF, you were well compensated for the increased volatility. If you wanted a pure overall technology ETF, then XLK was your best bet. All the others ETFs did not fare well in this comparison. They generally had relatively high volatility and lower returns. The nanotech ETF was the worst, having a high volatility coupled with a negative return.

Technology is a rapidly changing sector and the darling in one time period may not persist as new inventions are brought to market. To determine if the 3 year trend has endured over the last year, I generated another plot with a one year look back period. This is shown in Figure 2 and as you might have expected, there have been significant changes. During the last year, the SPY has been in a rip-roaring bull market and technology stocks have not kept pace, with the exception of the internet stocks. The semiconductor ETF, SOXX, has also moved to the forefront in terms of Sharpe ratio. For an overall pure technology play, the quant fund FXL has done the best but XLK is close behind. Nanotechnology has delivered positive returns over the last year but still lags in terms of risk versus reward.

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Figure 2: Reward and Risk for Technology ETFs (1 year)

Which are the best Technology ETFs? As you can see, it depends on the time period but FDN has been a standout performer over both time frames analyzed. For overall technology exposure, I would select either QQQ or XLK. So my top three picks would be FDN, QQQ, and XLK. However, depending on your risk tolerance and view of emerging trends, you might select others such as SOXX or FXL.

Source: Identifying The Best Technology ETFs