The risk-on trade is back on in full force through the first month of the new year. Money is flowing into equities with the S&P 500 (NYSEARCA:SPY) up 4.8% and hitting a new multi-month high in the process. The perceived "safety" sectors have been lagging with the consumer staple and utilities both in negative territory for the year. On the flip side the more aggressive sectors such as the financials and technology have been able to outpace the S&P 500 so far in 2012.
The sector that has grabbed my attention is the technology stocks. The SPDR Select Sector Technology ETF (NYSEARCA:XLK) is up 5.7% year-to-date and recently broke out to a four-year high. What makes XLK and the technology sector attractive is the potential to move higher with the risk-on trade working and there is also good valuation in the stocks that make up the sector. XLK currently trades with a forward P/E ratio of 12.5.
The number one holding in XLK is Apple (NASDAQ:AAPL), a tech darling that just reported record earnings that blew away expectations. The bullish news sent the stock to the best level ever and it helped propel a rally in XLK because it makes up 16% of the total allocation.
The top three holdings, that also include IBM and Microsoft (NASDAQ:MSFT), account for one-third of the total composition of the ETF. This could be a deterrent for many investors who seek more diversification in an ETF. My opinion is that if you like the top three holdings, it is not an issue. I currently do like all three and therefore this would not keep me from owning XLK.
If the heavy concentration on the top three holdings is an issue, an alternative is the Vanguard Information Technology ETF (NYSEARCA:VGT). The ETF has the same three holdings, but is more diversified with a total of 422 stocks in the allocation. The expense ratios are the same (0.19%), but VGT has been able to outperform XLK in 2012 with a gain of 7.6%.
Narrowing the Options
Within the technology sector there are niche sectors that are often overlooked or just ignored due to the lack of diversification. One that should not be overlooked any longer is the cloud computing sector. Of all technologies, cloud computing has one of the brightest futures due to what it offers its users. The ability to house large amounts of data in the cloud lowers the need for hardware in the office or home and increases accessibility and productivity.
The First Trust Cloud Computing ETF (NASDAQ:SKYY) is composed of 40 stocks that are either directly or indirectly involved in the cloud computing industry. The holdings range from pure-play cloud computing stocks to others that provide services or products to the niche sector. The ETF has had a great year so far, up 11.3%, easily beating the overall technology ETFs.
There is one issue I have with SKYY and that is the current makeup of the ETF. The top three holdings are Netflix (NASDAQ:NFLX), Equinix (NASDAQ:EQIX), and Akamai Technologies (NASDAQ:AKAM). One of my favorite stocks in the sector is EQIX, however NFLX and AKAM have had their issues and are a reason SKYY struggled in 2011.
In crunch time the decision comes down to whether to buy into the entire technology sector via VGT or get a little more aggressive and bet on cloud computing with SKYY. I have two thoughts on the situation. First, VGT could be considered a core holding in most portfolios as an all-encompassing technology investment that will satisfy the need for tech stocks. The second thought is that even though SKYY might not have been my ideal allocation for the cloud computing sector, it should move higher as money going into the sector will raise the tide and all ships will join in.
Lastly, for investors willing to consider individual stocks over ETFs, there is an option of buying a handful of technology stocks that have exposure to cloud computing and building your own ETF. For example, Taleo (NASDAQ:TLEO), which is not in the top 10 of SKYY, is one of my favorites in the niche sector and is a good place to begin.