What Tech ETFs Can Do for Your Portfolio

There's an ETF for every market sector you can think of. There are more than a few tech ETFs, and a ton of them have handily beaten the market lately.

In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Brian Feroldi explain how ETFs work then break down some of the biggest and most promising tech ETFs you can buy today. Tune in to learn what to look for when you buy an ETF, what kind of expense ratios to expect, the biggest risks to watch (and how to lessen them), how much holdings matter, and more.

A full transcript follows the video.

This video was recorded on March 22, 2019.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, March 22nd, and we're talking tech ETFs. I'm your host, Dylan Lewis, and I've got fool.com's Brian Feroldi on Skype. Brian, happy to have you back on the show!

Brian Feroldi: Dylan, thanks so much for having me! I love coming on!

Lewis: We are unfortunately pretaping this show. Fortunately/unfortunately. I'm going to be out of town. I'm going to be doing some traveling, so we cannot really get into the heat and commentary of March Madness. But because we have a long grudge with each other over sports teams, I just need to throw out there, my Northeastern Huskies, in the tournament. Your UConn Huskies, watching at home, Brian?

Feroldi: Yes, we did fail to make it. I will have to be rooting for my second-choice school, Northeastern, as they go through the tournament.

Lewis: Just had to get that dig in. We're in that magic period where teams are in the tournament. Aside from the people that lost in the play-in game, everyone still has a shot. By the time this episode goes live, my Huskies might already be out. So I'm not going to be celebrating too long, Brian.

Feroldi: I'll be rooting for them, no matter the outcome, though. That's the important thing.

Lewis: I appreciate your fandom. Today, we are going to be talking about a topic that we haven't really spent too much time on the show discussing before, and that's the ETF space. Brian, you want to give us a rundown on what an ETF is for people that are unfamiliar?

Feroldi: They're exchange-traded funds, and they are essentially a basket of different types of investments that are pooled together into a single entity, and then investors can buy shares of that entity. The ETFs are traded on a major stock exchange such as the NYSE or the NASDAQ. As an owner of the ETF, you get to own a proportional stake in the total asset base of the exchange traded fund. In that way, they kind of operate like a mutual fund, but there are some key differences between the two.

Lewis: Yeah, I'm guessing a lot of people heard that description and were like, "Wait a minute, I think that's a mutual fund." They are very similar in some ways. The main difference is, ETFs flow throughout the day. They can be bought and sold while the market is open, and they have prices that are constantly updating to reflect the values of what's in the basket. Mutual funds price daily, only transact at the end of the day. Some other big ones that you want to keep aware of. Mutual funds have minimums very often -- $1,000, $5,000. With an ETF, if you have enough to buy a share and cover your transaction costs, you can get started.

Feroldi: Yeah, that's right. Transaction costs are a big thing to keep in mind, because ETFs can be purchased through a brokerage account, and in many cases, you have to pay a commission on them. Sometimes with mutual funds, you do not have to pay a commission. So that is something to keep in mind.

Another benefit of ETFs is, for some types of investors, because they trade during the day, there are all kinds of extra things that you can do with ETFs that you cannot do with mutual funds. Advanced investors can short ETFs or use options or margin on them, stuff that can help to hedge or amplify risk that you can't do with mutual funds.

Lewis: Yeah. We're going to put all those actions in the catch-all of stuff that new folks can stay away from, and things that you really need to be sure you know what you're doing before you venture too far into. I think a lot of people think of ETFs, and they know that this is a space where typically, your fees are a little bit lower than what you'll see with mutual funds. You'll tend to see that on the management fee side. But your point earlier about commissions, that is something to be aware of. While generally, ETF fees are lower, if you're actively working in and out of ETFs, you're basically going to wipe the benefit of being in ETFs vs. mutual funds.

Feroldi: Yeah, you have to keep in mind the total dollar amounts that you're playing with and the commissions that you're paying. As you said, ETFs often have a lower expense ratio than a mutual fund. But if you are trading in and out of them, which is a silly idea in general for anything, all the benefits, all that lower cost, will be completely eroded by trading costs. That is something to keep in mind.

Lewis: Yeah, and even on an annual basis, or if you're looking at a two-year time horizon, say you have $1,000, you're paying $7 per trade. That's a 0.7% flat fee. Then, on top of whatever management fees there might be, very often the difference between a mutual fund and an ETF is only 10 or 20 basis points. So if you're paying 0.7%, in order to transact, that might eat away that difference, you might be better off tossing your money right into a mutual fund instead.

Brian, with all that nuance out of the way, I think the reason that ETFs are appealing to investors, same reason that mutual funds are interesting to investors, especially new folks. You buy one thing and you have instant diversification.

Feroldi: Yeah, that's a huge benefit of ETFs. ETFs have exploded in popularity over the last couple of decades. There are literally thousands of ETFs for investors to choose from. They segment the market up in any way that you can imagine. Here, we're going to talk about tech ETFs. Just as research for the show, I found 71 different ETFs that are just devoted to the technology space. They separate themselves in a number of different ways. Some own everything that's related to tech, where others take a niche focus and only buy semiconductor stocks or only cybersecurity stocks. Some of them take a regional focus, so they only focus in the U.S., or they only invest in China, or they only invest in Israel. Some are weighed by market cap, some are equal weighed, and some are even actively managed vs. passively managed. There are tons of different ways for investors to get exactly the exposure that they want with ETFs.

Lewis: Why don't we kick things off talking about the best-known ones? There's a very large class of tech ETFs that have done quite well over the last couple of years. Let's start with some of the big names, Brian.

Feroldi Sure. The first and the biggest tech ETF out there is called the Technology Select SPDR Fund, XLK. This is just an index fund that tracks all of the technology stocks that are components of the S&P 500. That includes 69 different holdings. This fund has been around for 20 years now. It's huge. It's got $20 billion in assets, it's very liquid, very easy for investors to get in and out. And even though it has a huge number of holdings, its expense ratio is very low, a 0.31% expense ratio. So if you want easy access to technology, you want to get exposure to all of the S&P 500 tech stocks, this is a very easy fund to invest in.

Lewis: As you might imagine, something covering the tech space is going to have a lot of exposure to the major players. That ETF has a lot of exposure to Microsoft and Apple. Combined, they make up about 35% of the exposure in the ETF. Brian, we can't talk ETFs and passive investing without talking about Vanguard, too.

Feroldi: Yeah. Big surprise, Vanguard has a fund, and big surprise, it's hugely popular. Vanguard's tech fund is called the Vanguard Information Technology ETF, VGT. This is an index fund that tracks information technology companies that exist beyond just the S&P 500. In this fund's case, there are 320 different stocks that are held inside of it. It's also very big. It's been around for 15 years, and it has $19 billion in assets under management. As you'd expect from any Vanguard product, it also boasts a very low expense ratio. This fund is just 10 basis points per year, very cheap.

Lewis: All right, we have one more that I think is part of the larger tech consciousness with ETFs, and that is First Trust Dow Jones Internet Index, FDN. Somewhat similar to the ones we've talked before. A little different, though.

Feroldi: Yeah. This is a market cap weighted index of the largest and most liquid U.S. companies that are just focused on the internet, which is obviously a very broad term. This fund holds 43 different companies. It holds about $8 billion in assets under management. It's been around for about 13 years.

One thing that separates this fund from the other two that we mentioned is it includes a little tech company called Amazon, which is actually classified as a retailer in many ways, so it's not included in some indexes, which is a little bit strange. This fund has done extremely well. It does have a much higher expense ratio than the other two we mentioned at 0.53%. It's nearly five times more expensive than the Vanguard product. Having said that, it does give you a more complete view, one could argue, of the tech sector because it does include Amazon.

Lewis: Brian, your point right there is exactly why you need to dig into what the underlying assets are for whatever you're investing in -- ETFs, mutual funds, doing your homework on individual stocks. You might buy an information technology ETF thinking you're getting exposure to Amazon, only to find out that the industry classifications aren't going to help you out there.

Feroldi: Yeah, it's always good, before you buy an ETF, just crack it open, look at the top 10 holdings. See how concentrated it is. See if it's market cap weight or equal weight. That can give you a much better idea of what you're investing in.

Lewis: Yeah. Looking at that class of ETFs, we have some pretty killer performance over the last couple of years compared to the S&P 500, Brian.

Feroldi: Yeah, all three of these funds that we just mentioned are big and they have just crushed the market. Over the last 10 years, the S&P 500 total returns, which means including dividends, is up 335%. That's obviously an outstanding performance on its own right. The XLK is up 468%. The VGT is up 551%. And the FTN, over that same 10-year stretch, is up 840%. So you're talking about 500% outperformance for the FTN vs. the SPY over the last decade.

Lewis: Yeah. That's why it's worth digging in, right? That exposure to Amazon, a little helpful in juicing those returns, Brian.

Feroldi: [laughs] Slightly helpful, yes.

Lewis: So, those are some of our broad-based ETFs that tech investors might want to have on their radar if they're looking for some instant diversification and nice exposure to the tech space in general.

You keyed up the fact that we have some more niche ETFs in there. Brian, let's dig into that.

Feroldi: Again, there's just dozens for investors to choose from. But as I was sifting through, three of them did catch my eye, and I thought that they could be worth mentioning on the show. The first one that I thought was worth highlighting was called the ARK Web x.0 ETF, ARKW. This is a little bit different of an ETF because it is actively managed. In this case, there is an investment manager that is calling the shots, picking individual stocks that are going into the fund. The theme behind this fund is, they're identifying stocks that are benefiting from the broad infrastructure shift away from hardware and software toward mobile and cloud. This fund holds 30 different holdings. It has a lot of Fool favorites that people, I'm sure, know, including NVIDIA, Tesla, Square, Twitter.

Because it's actively managed, it is much more expensive than some of the other funds we mentioned. The expense ratio here is 0.75%, which is probably unappealing to many people. However, this fund has only been around for five years, and the shift toward cloud and mobile has been so incredible, and this fund has a very Foolish investing style, that this fund is up 173% over the last five years. The S&P 500 is only up 57%. For people that are willing to take an actively managed ETF, I think this is a great choice.

Lewis: Some of the characteristics that you point out with this ETF are really the signs of something that is actively managed. You can look at some of them right off the bat -- smaller holding base, smaller AUM. It's a little bit easier to put up some pretty stellar returns when you're working with $500 million under management vs. $19 billion. And you can be a little bit tighter in what you own if you're in the active space.

Feroldi: Yeah. In this fund's case, the expense ratio that you're paying does give you direct access to a theme that I think is very powerful, which is the shift toward mobile and cloud, but you are paying more for that focus.

Lewis: Another major focus for tech investors over the last 5, 10 years is cybersecurity. Shocker, we have an ETF for folks like that, too, Brian.

Feroldi: Yeah. This ETF has a super fun ticker, HACK. This fund is called the ETFMG Prime cybersecurity ETF. It tracks equal weight index of companies that are involved in cybersecurity. If you believe that cybersecurity is going to become an increasingly big issue, and that companies that are focused on the space are increasingly going to grow in relevance, this is an interesting fund to choose from. They currently have 55 different holdings, lots of companies like Splunk, Palo Alto Networks, Check Point Software. It's a bit of a bigger fund. It's got about $1.7 billion in assets under management. Like we said before, because of the niche focus, the expense ratio here is higher, 0.6% per year, which is a little bit higher.

But the general trend toward cybersecurity has allowed this fund to outperform the S&P 500 by more than 20% since its inception in 2014. You are paying more, but you are getting, so far, pretty good performance.

Lewis: I'm sure a lot of people looked at that who have been interested in the cybersecurity space. I know for a while, I was a shareholder of FireEye, a cybersecurity company, and unfortunately rode that wave down. This has put up pretty good returns in a time where that company has struggled quite a bit. That's because you have that nice, broad exposure. You're not betting on one horse. You have a lot of players in that space.

Feroldi: Yeah, exactly. That's the big benefit of ETFs in general. They allow you to spread your money around, but you can still pick a theme that you like.

Lewis: Brian, this last ETF is one that we're stealing from the Monday Financials show, and that's a mobile payments ETF.

Feroldi: Yeah, I have a feeling that Jason Moser would be very happy about this ETF. This ETF is called the ETFMG Prime Mobile Payments ETF. Again, it has a really fun ticker -- IPAY. This ETF tracks credit card companies and anything that's providing infrastructure that has anything to do with payments and payment processing. So if you are into the war on cash, the theme that cash is gradually going to continue losing relevance, this is an interesting fund to play it.

This fund holds 33 different stocks. It has about $400 million in assets under management. It has outperformed the S&P 500 by 32% since its inception in 2015. The expense ratio here is 0.75%. Like it is for all these niche ones, you are paying more for that concentration. But if you're a believer in the war on cash and you want a very easy way to play it, I think IPAY is a decent choice.

Lewis: With all of these actively managed ETFs, I think an expense ratio below 0.1% for the types of returns they've put up is pretty reasonable.

Feroldi: Yeah, I completely agree. You're getting hyperfocused on a specific niche. If that niche does well, your fund will do very well. As long as the performance is there to justify the higher than expected expense ratio, it can make sense for investors to use these ETFs.

Lewis: As we wrap up here, Brian, I want to take a moment to talk about diversification. We say this is an easy way to get a lot of exposure to tons of different companies. The thing you have to keep in mind is, if you're in some of these more specialized ETFs, these more concentrated ETFs, yes, you're diversified in the sense that you may own a piece of 30 companies and the outcome of the ETF is going to be tied to their overall results; but, if you're in a very tailored ETF, something obscure, like a Chinese aluminum producer ETF, if that industry really struggles, it doesn't matter that you're diversified, the overall tailwinds aren't there for you.

Feroldi: Yeah, that is 100% accurate. If you in, for example, IPAY, and credit card processors and the whole war-on-cash thing doesn't work out, this fund will severely get crushed. That's why it's good to think of these ETFs as a complement to your regular investing style but not a complete replacement.

Lewis: Right. It might be worth owning a basket of ETFs in that case, Brian.

Feroldi: I think that's a great choice!

Lewis: Brian, thanks for hopping on and talking ETFs. You were the one that pitched me this show, so I was excited to have you on to talk about it. Anything else before I let you go?

Feroldi: No. Have a great time in Montana, snowboarding!

Lewis: Yeah, I'm excited! Listeners, if you reach out anytime in the next couple of days, I will not be able to answer any emails or tweets. I'll get back to you on Thursday of next week, when I'm back from snowboarding.

Brian, thanks for hopping on the show!

Feroldi: Hey, thanks for having me, Dylan!

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or you want to reach out and say hey, you can shoot us an email over at an [email protected], or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes, or you can check out the videos from this podcast over on YouTube. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Dan Boyd for all his work behind the glass today! For Brian Feroldi, I'm Dylan Lewis. Thanks for listening, and Fool on!

Check out the latest earnings call transcripts for the companies we cover.