Ultimately, the degree of diversification in an ETF investment would depend on current economic and secular trends, and how its portfolio accounts for future growth opportunities.
From worries last year of potential recession in 2024 due to elevated interest rates to core, the current economic landscape is a unique one. The Federal Reserve’s most recent rate decision penciled in one rate cut in 2024, and 5 projected rate cuts in 2025. Such hawkishness came amidst modest progress towards the committee’s 2% soft landing inflation target, compelling them to wait for clearer signs of disinflation, albeit positive news on core CPI. All in all, while month over month CPI data (Apr to May) reflected better than expected disinflation progress with a low print in May, factors such as price sticky CPI components under the defensive sector (not sensitive to interest rate effects) having yet to cool, to more frugal consumer spending habits and a tight housing market (causing shelter costs to remain higher) still go against the ideal end state scenario of a soft landing.
Combining all the market noise from weekly indicator data, with a shift in capital towards the US economy, this points us towards the general direction investors should face – I believe that all eyes should be focused on the US, and securities in line with shorter term cyclical US trends and desirable long-term growth potential are what investors need for more straightforward returns. Hence, all things considered, the Vanguard Information Technology index (NYSEARCA:VGT) is ideal as its portfolio composition is concentrated enough to reap the long-term momentum benefits of technological development, but also account for the volatilities in the economy today by diversifying across areas of information technology, strong quant ratings and indicators versus other ETFs, a unique portfolio, and ideal economic and secular conditions make VGT a must-have in portfolios. However, the risk of pullbacks in information technology equities, the nature of VGT’s concentrated portfolio, potential sector shifts and should also be acknowledged.
VGT is an ETF that highly specializes in information technology stocks. Its closest alternative would be the iShares U.S. Technology ETF (IYW) and the Invesco QQQ trust (QQQ). However, while the ETFs include 3 of the Magnificent 7 stocks that have taken public equities by storm (coincidentally the top 3 holdings in VGT), VGT’s portfolio comprises nearly 99% technology-based stocks, much higher than the 90.29% of IYW and 68.7% of QQQ.
To show how VGT stands out among other tech ETFs, I will examine why its rather high concentration in technology stocks has its benefits, and how it can make the best use of expected economic conditions in the years to come. Inversely, risks will be highlighted when sudden market downturns or sector rotations occur, making either specific areas of technology or the sector itself less attractive for investors.
In general, the 6 months after the final rate hike and after the first-rate cut has shown strong SP500 growth, with only 2/10 instances where the S&P 500 decreased in value. Putting this in context, this unprecedented, longer-term momentum we are seeing raises similarities with 1995, where easing measures were just implemented for a soft landing and the foundational stages of the internet were forming.
Comparing the Select Sector SPDR Fund ETFs above, it is obvious which sectors are leading the market – technology (XLK) and communication (XLC). Specifically, information technology. This segment of the technology super-sector strives to provide novel software, hardware, cloud and IT services to other companies and customers. Hence, history has shown that similar circumstances have led to economic boosts; boosts which would immensely benefit the hottest sector and thus VGT.
With the recent technology wave, sparked by rapid advancements and outstanding earning reports, investor interest has been immense. In particular, semiconductors currently ride this technology wave. Companies along various parts of the supply chain are seeing record-breaking earnings and exceeding expectations, from the pure-play chip producers like Taiwan Semiconductor Manufacturing Company Limited (TSM) to Fabless companies like NVIDIA Corporation (NVDA), to IBDs that integrate both components such as Samsung (OTCPK:SSNLF) and Intel Corporation (INTC), increasing YoY cash flows by 40%, 81%, 25% and 34% respectively. This has opened up immense capital expenditure plans to develop further capabilities and better meet increasing computational power demands.
This leads me to why I found VGT the most apt to reap future growth. Evidently, hardware is thriving due to its ability to power products and processes vital for companies in all industries. Collaborations between AI generating platforms to scale up developments. This includes bringing MSFT Azure to ORCL’s Cloud Infrastructure to expand OpenAI’s LLM platforms. However, we need to acknowledge that software is starting to fulfill its immense potential, as capabilities like generative AI, automation, cloud computing and augmented data analytics have begun perforating and integrating into other industries, platforms and thereafter products and services. Notably, secular trends in electric vehicles, clean energy and generative artificial intelligence involve the broad-scale adoption of large language models.
Hence, while stocks such as INTC, Broadcom, Qualcomm, AMD and NVDA have done well so far, it will be time for technology to broaden towards software-oriented areas within this ETF. First, AAPL has announced investments worth $1.5B with OpenAI to integrate its ChatGPT and image processing capabilities to its IOS platforms, which are accessible to most AAPL devices. ADBE is working with MSFT and OpenAI to make generative AI more integrated into its suite of platforms, such as Premiere Pro for video editing and Acrobat Assistant for improved document workflow. Conversely, for integrated marketing insights, MSFT and ADBE are working together to bring these ADBE Experience Cloud workflows to MSFT 365 services like Outlook to Excel.
With VGT’s top holding software companies not only working with hardware platforms, but also among each other’s platforms to streamline work processes, this builds a solid software foundation for technology services that will become vital for companies outside of tech, aiding information analysis and management. This aligns nicely with VGT’s software-heavy portfolio and shows the immense value its holdings can add through its consumer targeted platforms, making it attractive to longer-term investors.
Unsurprisingly, now is a great period for tech ETFs to thrive with trends towards artificial intelligence perforating not only into software or hardware technologies, but also beginning to see plans for integration in other industries to make processes more efficient. As seen below, most ETFs have grades of A and A+, with exceptions in areas such as dividends and risk. For dividends, the priority when investing in tech are the strong, steady returns that come from technological trends and advancements, and not dividends. Thus, dividends should not be a principle consideration for diversifying into technology.
VGT’s risk profile is largely attributed to the nature of the ETF, differing greatly from all other rated ETFs. First, the % of assets in the top ten holdings, or the “10 firm concentration ratio”, is 58.8%. While higher than the median, it is compared with other ETFs, thus any other tech or industry focused ETFs will naturally offer greater diversification and lower weights in their top 10 stocks because of how concentrated technology stocks are in VGT. Second, the standard deviation for VGT, QQQ, XLK and SMH are either C or D ratings, but considering that technology stocks face greater industry-specific fluctuations due to rapid developments in technology and thus growth, its price tends to be more volatile than the general economy. Here, the current economic landscape leverages on this, as the higher risk is due to strong returns YTD.
With that said, among technology ETFs, VGT holds the highest overall grades, justifying its “Strong Buy” quant rating of 4.60. An additional bonus is its 0.10% expense ratio, one of the lower ratios in its comps (0.03% to 0.35%).
We discussed how we are hovering in a Goldilocks zone while waiting for a likely cut decision, which is just a matter of time. However, what happens when technology stocks explode in growth and bubbles begin to form as future financial expectations become increasingly harder to meet.
The dislocation between the magnificent 7 and the remaining 493 companies in the SP500 has gotten increasingly apparent. Bloomberg Intelligence data suggests that this lack of market breadth has reached “one of the worst levels in three decades”. Just by looking at YTD and 1 year returns in terms of percentage, 5/7 stocks greatly outperform the market in gains, with the exceptions of TSLA and AAPL who have justifiably devoted billions to AI integration and have yet to see clear results in the short term.
We have already seen instances of pullbacks of technology stocks as recent as last week, with NVDA down nearly 13% in 2 days. When companies start performing too well and keep adding on to the momentum and hype by investors, this leads to unrealistic forward P/E ratios that would otherwise require a nearly exponential increase in revenues for subsequent quarters to meet that investor demand. Even if superstars like NVDA, AAPL or TSMC manage to meet ever so high earning expectations for the time being, these streaks cannot go on forever. What goes up must come down, and increasing prices will make investors more sensitive to bad news, or at least wonder when the bullish rally will reverse. Hence, for ETFs that are relatively concentrated like VGT, valuations can lead to brutal price cuts once investor hesitation due to company news, or worse industry news kicks in. When even analysts within the company cannot predict how fast growth could be in the future, intrinsic valuation and thus required price corrections become difficult to track.
Thus, if we see the P/E ratios for superstars like NVDA, MSFT and AAPL climb to unrealistic levels, or prices begin pulling back rapidly if quarterly reports do not meet earning expectations, then information technology focused ETFs may not be ideal for investors.
Besides technology being all the craze now, another thriving sector is utilities. Utilities have also benefited from the technology craze, returning 13% in the 3 months through June 7th and outperforming all 11 sectors in the time period. XLU in particular gained 10%.
What draws investors to the sector is its defensive nature. Utility equities provide even more stability against external headwinds than technology ones because the power required for technology driving capabilities will directly boost utilities. Hence, as AI becomes more power consuming, and the yields of utility companies and ETFs begin to increase thereafter, the risk (reduced) to reward (raised) profile of utilities become increasingly attractive.
Utilities is not the only sector that is beginning to see benefits. Another defensive sector that is thriving thanks to artificial intelligence is healthcare. YTD, XLV has seen a 7.34% increase, becoming the 4th best performing sector behind XLK, XLC and XLU. There is much room for AI to integrate into healthcare, first into administrative AI, which faces fewer regulatory and adoption hurdles, and afterward clinical AI. A report by Silicon Valley Bank found that $2.8B had already been invested in the sector, with $11.1B in venture capital to be deployed in 2024 and total funds projected to be $16.9B, a 74% increase from funds raised in 2023. With 1 in 4 dollars invested in healthcare directed towards companies leveraging on AI, this again injects high-growth opportunities to a sector that is stable by nature.
Hence, 2 out of the 3 defensive sectors in 3rd and 4th place behind technology and telecommunications in returns thus far in 2024. Investors may be better off either buying ETFs with greater diversification towards defensive sectors to reduce risk, and instead investing directly into larger market cap technology or communication stocks that have been performing well for more directed returns, notably those in the magnificent 7.
If we see defensive sectors begin to see healthy short-term yields, this could indicate investor interest towards them, and the need to consider securities in these areas for a balanced portfolio.
As mentioned, hardware forms a solid foundation for future software development. Thus, the lack of other companies involved in the hardware supply chain in VGT means it is missing out on additional returns and reduced risk. For instance, semiconductor companies form 29% of VGT, so adding pure-play foundries such as TSM or GlobalFoundries (GFS), and even companies that support these foundries like ASML or Applied Materials (AMAT) since there is still room for processing technologies to scale up and thus demand for these companies at the lower ends of the supply chain have been great.
However, a shift in focus towards AI applications has led to reduced appreciation for the back end of hardware companies powering such capabilities. Comparing trading multiples (GAAP), we can see that AMAT, TSM and GFS hold lower than average TTM P/E ratios in the trailing twelve months (ASML slightly above average), showing that their growth has been well grounded in expectations. Considering that the betas for the 4 companies are below or close to the mean, it also shows their stability in market returns.
On the other hand, I look at forward PEG to account for growth expectations. The mean PEG is X1.6 excluding ADI, while GFS, AMAT, and ASML have PEG ratios above the 75th percentile. This means that there are high investor expectations for GFS, AMAT and ASML for the near future.
Considering the high growth of the technology sector, and betas above 1 for the 4 companies, such PEG ratios can have a silver lining, and VGT can benefit from the remaining strong gains they could offer, yet with slightly reduced risk as companies that support the front-runners of hardware technologies.
Thus, if we see the growth of software-based companies being underwhelming in the coming quarters, or if companies in the back end of hardware supply chains see stronger gains due to its appeal of relative stability, then VGT may not be the most optimal ETF for returns. More balanced tech ETFs like QQQ would be less impacted by slowed software developments, and would better leverage on the safer foundries and machine manufacturers in the sector.
VGT is a great buy for investors. First, its unique portfolio composition concentrated enough to reap the long-term momentum benefits of technological development, but also account for the volatilities in the economy today by diversifying across areas of information technology. Secondly, current economic and secular trends that are ideal for VGT’s portfolio growth. Lastly, strong quant ratings and indicators versus other comparable ETFs, make VGT a buy. However, the risk of pullbacks in information technology equities, the lack of “back-end” support companies in VGT’s portfolio and potential sector shifts can cause VGT as well as technology ETFs in general less suitable for investors.
Ultimately, the degree of diversification in an ETF investment would depend on current economic and secular trends, and how its portfolio accounts for future growth opportunities.
