The cybersecurity industry has made plenty of headlines lately due to a global surge in data breaches and cyberattacks. In January, the Identity Theft Resource Center and CyberScout reported that data breaches in the U.S. had risen 40% in 2016 to a record high. Research firm Markets and Markets estimates that the global cybersecurity market will grow from $122.5 billion to $202.4 billion between 2016 and 2021.

A simple way for investors to track the performance of the industry is to follow the PureFunds ISE Cyber Security ETF (NYSEMKT:HACK), which owns a diversified basket of top cybersecurity stocks. The ETF's 23% gain over the past 12 months looks solid, but the industry still faces several big challenges this year.

Chart showing PureFunds ISE Cyber Security ETF 12-month returns

Data source: Nasdaq. Chart by author.

First, many smaller cybersecurity companies generate impressive revenue growth but are unprofitable due to the high costs of research and development, marketing, and stock-based compensation. Without consistent profitability, these stocks could collapse during market downturns.

Larger tech companies like Cisco Systems and Microsoft are beefing up their bundled cybersecurity products, which could lead to smaller players being acquired or marginalized. That market consolidation means that it may be safer to stick with the bigger companies, which have well-diversified, end-to-end business models, than lesser ones offering a narrower portfolio of services.

Nonetheless, smaller "best in breed" cybersecurity companies like next-gen firewall provider Palo Alto Networks might continue growing if their customers aren't lured away by those bigger players. Investors should keep all these facts in mind when screening for potential investments across the fragmented cybersecurity market.

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