XLK Technology Select Sector

The technology sector delivered a stellar performance last year, but has been unable to provide meaningful support to earnings growth of the S&P 500 index of late, despite being the second largest earnings contributor (about 17.5%) to the index. The total earnings for the sector is expected to slip 1% in Q1 on 2.2% higher revenues and a 52 basis-point decline in net margins (read: 3 ETFs in Focus on Apple Earnings Results).

The mood can further be validated by the biggest daily drop in the tech-laden Nasdaq Composite Index in mid March since early February. Most of the large tech ETFs strived hard to deliver even one percentage point return over the past one month. Some seasonality issues, tough comparisons and overvaluation can be blamed for this burst in the tech bubble.

However, investors should not be bogged down by this slowdown. Rather they can play the correction by looking to buy in to technology stocks, in individual or in basket form. The sector is expected to speed up earnings growth from this year and the next. As per the Zacks Earnings Trend, earnings from this industry are expected to go up 10.1% in 2014 and 11.5% in 2015. Revenues are expected to grow 3.9% in 2014 but decline 5.4% in 2015.

In fact, Q1 is supposed to be the last quarter of earnings decline as from 2Q the sector is slated to gather some momentum. As of now, Zacks Earnings Trend has modeled 6.8% earnings growth for 2Q, 8.8% for 3Q and 7.6% for the concluding quarter of the year. Revenues will likely jump 3.3% in 2Q and 5.0% in 3Q.

Given this potential, a look at some of the top ranked ETFs in the technology space could be a good way to target the best of the segment with lower levels of risk. In order to do this, investors can look at the Zacks ETF Rank and find the top ETFs in the above mentioned sector (read: Top Ranked Technology ETF in Focus: QTEC).

About the Zacks ETF Rank

The Zacks ETF Rank provides a recommendation for the ETF in the context of our outlook for the underlying industry, sector, style box or asset class (Read: Zacks ETF Rank Guide). Our proprietary methodology also takes into account the risk preferences of investors. ETFs are ranked on a scale of 1 (Strong Buy) to 5 (Strong Sell) while they also receive one of three risk ratings, namely Low, Medium or High.

The aim of our models is to select the best ETFs within each risk category. We assign each ETF one of the five ranks within each risk bucket. Thus, the Zacks ETF Rank reflects the expected return of an ETF relative to other products with a similar level of risk.

For investors seeking to apply this methodology to their portfolio in the technology space, we have taken a closer look at the top ranked FXL. This ETF has a Zacks ETF Rank of 2 or ‘Buy’ rating (see the full list of top ranked ETFs) and is detailed below:

First Trust Technology AlphaDEX Fund (FXL)

This fund looks to have an enhanced exposure to the StrataQuant Technology Index. The index uses the AlphaDEX methodology to select stocks from the Russell 1000 Index. Stocks are screened on the criteria of higher price appreciation, sales to price and one-year sales growth, book value to price ratio, cash flow to price ratio and return on assets.

The best part of the index is that it uses a smart beta technique instead of focusing on plain vanilla market cap oriented approach. It ranks the stocks in the space by various growth and value factors, eliminating the bottom ranked 25% of the stocks. As such, FXL should generate positive alpha relative to traditional passive indices since it uses AlphaDEX methodology and allots higher weight to more favorably ranked firms.

This ETF invests about $838 million of assets in 90 securities. The portfolio is well balanced across individual holdings, capitalization and style. No stock occupies more than 2.36% of total assets. Its top three holdings include Ingram Micro, Brocade Communications and Tech Data Corp.

FXL is also less exposed to the rather struggling Internet and hardware industry of the technology sector. As far as capitalization is concerned, mid-caps rule the category with almost half share of the basket followed by large caps (37%) and small caps (12%) (Read: Best ETF Strategies for 2014).

For this unique exposure, the fund charges 70 basis points in annual fees which is slightly costly in the technology ETF space. The fund has gained about 26.2% in the past year time frame in contrast to the 19.3% gain seen in the biggest fund in the space – SPDR Technology Select Sector Fund (XLK) – as well as another top tech ETF from Vanguard, VGT, which added about 23.8% in the time frame.

We currently give FYT a Zacks ETF Rank of 2 or ‘Buy’ rating along with a medium risk outlook, so we are looking for this stretch of relative outperformance to continue, though the fund is clearly capable of some big moves in short time frames.

Bottom Line

In a nutshell, the technology sector has been broadly mixed so far this year due to the broader market slump and uncertainty surrounding some of the top tech players. The sector may have a rocky earnings season coming up, so volatility may continue.

In such a scenario, investors need to deal with extra caution while landing on some investment options in the space. And to accomplish the goal, a smart beta approach like FXL should do the trick.

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FT-TECH ALPHA (FXL): ETF Research Reports
 
VIPERS-INFO TEC (VGT): ETF Research Reports
 
SPDR-TECH SELS (XLK): ETF Research Reports
 
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