Those who take a contrarian view and are willing to brave potentially choppy near-term winds in coming months should consider this ETF.
In recent months, the semiconductor sector has come under pressure. Investors have soured on chipmakers amid softening demand that has been caused by continued uncertainty in Europe and a less-than-stellar personal-computer market. The entire sector has fallen by 13% in the past three months, driving down exchange-traded funds that track the semiconductor industry. For a contrarian investor, however, the time to consider investing may be approaching. Earnings reports are just around the corner, and whether chipmakers disappoint or not, industry players will at least clear up some level of uncertainty. And there are good reasons to expect a longer-term rebound for the sector. Although the PC end market may well be stalled, the industry stands to continue to benefit from the new releases of a wide variety of technology products, such as Apple's AAPL new iPhone and computer hardware makers' new Ultrabook innovation. Also, as the economy continues its long slog toward recovery, we expect corporate spending on IT--and especially on data center technology and networking infrastructure, both of which need semiconductors--to remain strong.
We recommend Market Vectors Semiconductor ETF SMH as the most appropriate way to tap into the semiconductor market. The fund holds 25 of the largest semiconductor players, has an attractive 0.35% price tag (tied for the lowest relative to all of its peers), and trades at a compelling 85% of its fair value. By comparison, other broad-based tech ETFs are not trading at such discounts, nor is the broader market as a whole. For example, SPDR S&P 500 SPY trades at 89% of fair value, while Technology Select Sector SPDR XLK trades at 89% of fair value, Fidelity Nasdaq Composite Index Tracking ONEQ trades at 92% of fair value, and PowerShares QQQ QQQ trades at 89% of fair value.
As a subsector-specific ETF, SMH invests in semiconductor firms and semiconductor capital equipment firms and should be viewed as a tactical investment, suitable only as a complementary satellite holding to a diversified portfolio. Because of its narrow sector focus, this ETF lacks the diversification of broader funds.
Semiconductor firms are more cyclical and more volatile than other kinds of tech companies. SMH's narrow industry focus means there is little overlap with broad market ETFs--semiconductor firms make up 1.8% of SPDR S&P 500 and 9.6% of the tech-heavy PowerShares QQQ.
While the semiconductor industry may be heading into a bit of a rough patch right now, over the longer term we are not worried about demand in the semiconductor space; often, chip downturns simply are reflections of just how cyclical the semiconductor industry is. For example, some customers have drawn down inventories on fears that current turbulence in the financial markets could hamper sales. And a variety of one-time events have caused problems as well, such as flooding in Thailand (which has hampered hard-disk-drive production and disrupted the PC-supply chain).
Because the semiconductor industry is very cyclical, investors may find it useful to follow some industry metrics. The Semiconductor Industry Association's website provides industry data and releases a three-month average of global semiconductor sales around the first of every month. The SIA reported that industry sales grew in the low single digits in 2011, driven by demand in tablets and PCs, and the association forecasts further improvement in 2012. Through the first quarter of 2012, sequential sales growth had taken place across all regions, with association officials projecting momentum to build throughout the year.
Generally speaking, the trends in monthly sales tend to lag the price performance of semiconductor stocks, but historical data can help provide some perspective on the current cycle. A somewhat more prospective data point could be the three-month moving average of orders to North American semiconductor equipment firms (these firms sell manufacturing equipment and tools to semiconductor companies) and a book/bill ratio, which can be found at semi.org. A book/bill ratio higher than 1 implies that recent new orders are outpacing current shipments, which would suggest that semiconductor companies are optimistic about near-term demand. As of this writing, the industry's book/bill ratio has slid a bit in recent months. However, the book/bill ratio still points to overall optimism for the sector, as it remains above 1.0. The May 2012 book/bill ratio was 1.05, down slightly from 1.10 in April 2012 and a high-water mark of 1.12 in March 2012.
This ETF employs full replication to track a market-capitalization-weighted, rules-based index of the 25 largest U.S. listed, publicly traded semiconductor and semiconductor-equipment companies. This ETF is fairly concentrated, with the top five holdings comprising just more than 50% of assets, and the top 10 holdings making up more than 71% of assets. This is a very high-quality portfolio. Almost 33% of this ETF's assets are invested in companies with wide economic moats, with another 51.5% invested in firms with narrow moats. About 72% of the assets in this ETF are invested in companies based in the United States (although all of this ETF's holdings trade in the U.S.). The remaining assets are invested in firms domiciled in Taiwan (13% of this ETF's assets), the Netherlands (5%), the United Kingdom (4%), Singapore (3%), and Bermuda (2%).
This ETF charges 0.35%, which we consider to be a reasonable fee for a subsector-level fund. The fee is identical to the expense ratio charged by the semiconductor ETF SPDR S&P Semiconductor XSD. The other two semiconductor ETFs charge more.
SMH is the largest and most liquid semiconductor ETF. However, investors seeking semiconductor exposure have three other ETF options. A slightly more expensive and less liquid option is iShares PHLX SOX Semiconductor Sector SOXX, which charges 0.48% and holds 30 companies. Like SMH, SOXX is a market-cap-weighted ETF. While SOXX has a higher price tag and is less liquid, it also holds companies that are slightly more undervalued. At present, SOXX trades at 83% of its fair value.
Another option is SPDR S&P Semiconductor, which charges 0.35%. XSD holds 48 semiconductor companies that it equally weights, so its portfolio tilts more toward small- and mid-cap stocks than does the iShares offering.
Still another possibility is PowerShares Dynamic Semiconductors PSI (0.63% expense ratio), which is a 30-stock portfolio with weightings based on the dynamic Intellidex methodology.
Investors seeking broader technology-sector exposure can consider Technology Select Sector SPDR (0.18% expense ratio) and Vanguard Information Technology ETF VGT (0.19% expense ratio). The two funds are almost perfectly correlated.