Tech Sector ETF Rankings for 3Q11

by: David Trainer

ProShares Ultra Semi­con­duc­tors (USD) is our top pick among the 25 ETFs we ana­lyzed for our 3Q11 update on the Best & Worst Tech Sec­tor ETFs.

The tech sec­tor is one of only two sec­tors to earn our “attrac­tive” rat­ing. For our pre­dic­tive rat­ings on all 10 sec­tors, see our 3Q11 Sec­tor Roadmap. Last quar­ter, the tech sec­tor got a “neu­tral” rat­ing. As val­u­a­tions declined and the eco­nom­ics of tech com­pa­nies con­tinue to stay strong, the invest­ment merit of com­pa­nies in the sec­tor improved and enabled the sec­tor to improve its risk/reward rat­ing to attractive.

But do not be fooled by an attrac­tive rat­ing. It does not mean that every tech sec­tor ETF is worth buy­ing. In fact, quite the oppo­site is true. Only nine out of the 25 tech sec­tor ETFs get our attrac­tive rat­ing and are worth buy­ing. 15 tech sec­tor ETFs get our “neu­tral” rat­ing, which means they offer about the same risk/reward poten­tial as the S&P 500 but with less diver­si­fi­ca­tion. And one tech sec­tor ETF, Pow­er­Shares Dynamic Net­work­ing (PXQ), gets our “dan­ger­ous” rat­ing, which means you should sell or short it.

The attractive-rated ETFs earn their rat­ing by allo­cat­ing to attractive-or-better-rated stocks such as Apple (AAPL), Google (GOOG), Intel (INTC) and San­Disk (SNDK). Fig­ure 1 shows how the infor­ma­tion tech­nol­ogy sector’s stocks and the mar­ket value attrib­uted to them stack up under the micro­scope of our pre­dic­tive risk/reward rat­ing system.

Fig­ure 1: Tech­nol­ogy Sec­tor – Allo­ca­tion & Hold­ings by Pre­dic­tive Rating

[Click all to enlarge]

Sources: New Con­structs, LLC and com­pany filings

The IT sec­tor has only 13% of its value invested in dangerous-or-worse-rated stocks and 65% of its value invested in attractive-or-better-rated stocks. Though the tech sec­tor is heav­ily weighted toward attractive-or-better stocks, there are still plenty of dangerous-or-worse-rated stocks that investors should be care­ful to avoid.

Fig­ure 2: Hold­ings Count of Tech­nol­ogy Sec­tor ETFs

* # of Hold­ings excludes cash

Sources: New Con­structs, LLC

Fig­ure 2 shows clearly that tech sec­tor ETFs are not all made the same. Dif­fer­ent ETFs have mean­ing­fully dif­fer­ent num­bers of hold­ings and, there­fore, dif­fer­ent allo­ca­tions to hold­ings. Given the dif­fer­ences in hold­ings and allo­ca­tions, these ETFs will likely per­form quite differently. Con­se­quently, it is impor­tant to derive a pre­dic­tive rat­ing for ETFs based on analy­sis of the under­ly­ing qual­ity of earn­ings and val­u­a­tion of the stocks in each ETF.

Fig­ure 3 shows how the 25 tech sec­tor ETFs stack up ver­sus each other, the over­all sec­tor and the S&P 500 based on their risk/reward rat­ings and the allo­ca­tion of their hold­ings by rating.

Fig­ure 3: Invest­ment Merit Based on Hold­ings and Allocations

Sources: New Con­structs, LLC and com­pany filings

Attrac­tive ETFs:

USD, QTEC, XLK, TYH, IYW, ROM, FTQ, IGM and VGT earn an attractive or better over­all risk/reward rat­ing and there­fore are the only U.S. equity tech­nol­ogy ETFs we rec­om­mend. Our top pick from this group is USD.

Neu­tral ETFs:

SOXX, SOXL, MTK, RYT, PTF, PSI, IGN, FXL, XSD, PSCT, IGV, PSJ, FDN, PNQI, and SKYY allo­cate their value in a way that earns them a neu­tral over­all risk/reward rat­ing. We rec­om­mend investors buy the very attrac­tive and attrac­tive stocks in this sec­tor before buy­ing any of the U.S. equity tech­nol­ogy ETFs except those we rec­om­mend.

Dan­ger­ous ETFs:

We rec­om­mend investors avoid PXQ because of its dan­ger­ous over­all risk/reward rating.

Our analy­sis is based on aggre­gat­ing results from our mod­els on each of the com­pa­nies included in every ETF and the over­all sec­tor (574 com­pa­nies) based on data as of July 12. We aggre­gate results for the ETFs in the same way the ETFs are designed. Our goal is to empower investors to ana­lyze ETFs in the same way they ana­lyze indi­vid­ual stocks. Given the suc­cess of our rat­ing sys­tem for indi­vid­ual stocks, we believe its appli­ca­tion to groups of stocks (i.e. ETFs and funds) helps investors make more informed ETF and mutual fund buy­ing deci­sions. Barron’s fea­tured our uniquely pre­dic­tive ETF research in The Dan­ger Within.

Disclosure: I am long AAPL, GOOG, INTC.