Seeking Alpha
Profile| Send Message|
( followers)  

This year has not been kind to telecommunication ETFs, as increased competition for existing users has begun to weigh heavily on the sector. In addition, growth opportunities, which long have been a hallmark of the telecom industry, appear to be drying up. According to a new report, two-thirds of all people on earth now use a cell phone, and prices have dropped more than 15% since 2008.

While a decline in costs is good news for consumers, funds in the communications ETFdb Category have felt the pinch, as nearly every telecom ETF is in the red for the year. However, one ETF has outpaced its rivals and actually delivered a positive return thus far into the year. The PowerShares Dynamic Telecom (PTE) has gained about 4.4% on the year, while the remaining funds in this category have delivered an average loss of about 4% so far in 2010.

So what’s behind the big performance gap among telecom funds? The answer lies in the benchmarks to which these products are linked.

PTE is designed to track the performance of the Dynamic Telecommunications & Wireless Intellidex Index, an “enhanced” benchmark that uses a quantitative screening process to identify stocks within the telecommunications and wireless industries that have the greatest potential for capital appreciation. The universe of possible index constituents are evaluated on several criteria, including fundamental growth, stock valuation, and investment timeliness. It’s also important to note that this index employs a modified equal dollar weighting strategy, which limits the allocation that can be made to any one security.

The impact that the index methodology has had on 2009 returns emerges when the holdings of PTE are compared to other telecommunication ETFs, specifically the HOLDRS Merrill Lynch Telecom (NYSEARCA:TTH) and iShares S&P Global Telecommunications Index Fund (NYSEARCA:IXP). PTE’s exposure is spread more equally across component companies, as no single stock accounts for more than 5% of assets and the top ten holdings account for about 45% of assets. By comparison, the top ten holdings account for 100% of TTH and two-thirds of IXP.

The differences are even more striking when considering allocations made to individual holdings. As presented in the table above, the weightings given to AT&T (NYSE:T) are vastly different between these three telecom ETFs. AT&T is the seventh largest component of PTE, but constitutes more than half of TTH and just under 15% of IXP. This discrepancy is responsible for a big portion of the year-to-date return gaps. AT&T has dropped more than 13% this year, as worries over an overloaded network have spooked investors wondering if the company will have to significantly increase its capital spending in the near future to stave off a customer revolt.

Significant concentration in a mega cap equity won’t always cause an ETF to underperform. When AT&T’s stock price is soaring, TTH (and IXP to a lesser extent) will get a nice boost. But the big gaps in telecom funds over a relatively short period of time show just how important an index choice can be to bottom line returns. When selecting an ETF in a particular industry, it is vital to take a look under the hood of the related benchmark, analyzing the methodologies employed to select component companies, determine individual weightings, and complete the rebalancing process.

Disclosure: No positions at time of writing.

Source: Telecom ETFs: What's Driving PTE?