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Our Favorite Tech ETF: A Low-Cost Way to Tap Into Mobile-Computing Growth

There's much to like about this broad U.S. technology ETF--high-quality companies, stability, and even a dividend. For the sector to go higher, companies tied to mobile computing will lead the way.

Robert Goldsborough, 11/08/2013

Morningstar's Take
As the U.S. stock market has continued its climb in 2013, investors in large- and mid-cap U.S. technology stocks might wonder whether there's much more runway left. Certain technology subsectors, such as Internet and semiconductors, have done very well, while some tech players, such as Apple AAPL and IBM IBM, have underperformed both the sector and the broader market.

The bull case for the U.S. technology sector revolves around companies that have lagged the broader market but are expected to benefit nicely from continued strong growth in mobile computing, such as Apple, Qualcomm QCOM, and Broadcom BRCM. These firms all possess structural competitive advantages, economic moats, reasonable valuations, and exposure to mobile computing. Further gains in the tech sector likely will come from companies benefiting from mobile computing, such as these firms.

For investors interested in technology, we recommend Vanguard Information Technology ETF VGT. The fund offers an inexpensive way to tap into some of the best parts of the U.S. tech sector, such as its continual growth, its "moaty" aspects, and its growing income potential, while at the same time providing a certain stability for investors.

As a sector-specific exchange-traded fund, VGT should be viewed as a tactical investment, suitable only for the satellite portion of a diversified portfolio. Over the past five years, VGT had a volatility of return of 20.7% compared with 18.0% for the S&P 500 Index.

VGT holds mostly large, well-established technology firms and holds a large number of stocks (414). It does have a top-heavy aspect to it, with its top-10 holdings making up a significant 53.5% of the portfolio. At the same time, VGT has a very high-quality portfolio--wide-moat and narrow-moat firms account for about 51.5% and 31% of the portfolio, respectively, meaning that Morningstar's equity analysts believe that more than 82% of VGT's assets are invested in firms with sustainable competitive advantages.

The heavyweight technology ETF is Technology Select Sector SPDR XLK. Vanguard Information Technology ETF differs from XLK in that it holds a much broader portfolio than the SPDR's 73-name portfolio. Plus, VGT devotes more than 22% of its assets to small- and mid-cap tech companies, while XLK invests just 9% of its assets in small- and mid-cap firms. However, the two ETFs' performances are very highly correlated (99%), so the practical effect of these portfolio differences isn't great. And a quick look at the two ETFs over the past six years shows that the two funds have performed almost identically. Given that VGT's 0.14% price tag is slightly lower than the XLK's 0.18%, this ETF is our favorite technology-sector ETF.

Fundamental View
The single largest dynamic affecting the U.S. technology sector right now is the ongoing shift toward mobile computing and the growth in cloud computing. Mobile and cloud computing are truly a disruptive force in the tech sector. As users shift to mobile devices, PC sales continue to fall. Morningstar's equity analysts expect global PC shipments to drop 8% this year, with the multiyear declines in developed markets now being accompanied by moderate declines in emerging markets. Despite declines in PC sales, the total number of devices sold actually is expected to rise meaningfully in the years to come, as consumers and businesses adapt to smartphones and tablets. In fact, our analysts project that in 2017, some 2.6 billion-plus computing devices will ship--more than twice the total number of devices that shipped in 2012.

Across the U.S. tech sector, firms have been reshaping their portfolios for this ongoing transition. Microsoft MSFT recently acquired Nokia's NOK handset business and has developed the Windows Phone operating system, while Intel INTC has been investing heavily in producing microprocessors optimized for mobile devices. Apple long has been at the head of the pack with its iPhone and iPad, continually gaining share from struggling competitors such as HTC, BlackBerry BBRY, and Nokia. And Google GOOG long has had a dominant position in Internet search but has been very successful at aggressively investing in its Android operating system for smartphones and tablets and providing it free of any license fees, which means that having Google software on the device helps to ensure that when users search, they use Google.

Robert Goldsborough is an ETF Analyst at Morningstar.
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