The evolution of the ETF industry continues to spawn innovative products that open up the doors to asset classes and strategies that were not too long ago simply out-of-reach for the average investor. Innovation in the form of granularity recently struck the technology ETF space with the launch of the PureFunds ISE Cyber Security ETF (HACK).
We recently had a chance to talk with ETF industry expert Christian Magoon, who is also a consultant to ISE ETF Ventures, which is dedicated to supporting innovative indexes that offer exposure to growing industries; he shared his insights about the cyber security industry as a whole in addition to taking a deeper dive under the hood of the recently launched HACK fund.
ETF Database (ETFdb): What was the inspiration behind creating an exchange-traded fund linked to the ISE Cyber Security Index?
Christian Magoon (CM): The inspiration behind the PureFunds ISE Cyber Security ETF (HACK) was twofold: the capital appreciation potential of the cyber security industry and the lack of an investment vehicle to efficiently access these companies.
First, the capital appreciation potential of cyber security companies is primarily driven by the growth rate of cybercrime and the corresponding need to protect against it. The relationship between industry growth and the need for protection offers an intriguing investment proposition. Second, until HACK’s launch, investors lacked an efficient way to access a basket of professionally selected cyber security companies that traded throughout the day. HACK provides an efficient point of access for investors interested in cyber security companies.
ETFdb: What is the objective of the fund? Please walk us through the portfolio construction process.
CM: The fund seeks to provide investors with convenient exposure to a professionally selected basket of companies focused on cyber security solutions. In an effort to accomplish this, HACK seeks investment results that correspond generally to the price and yield, before fund fees and expenses, of the ISE Cyber Security Index. The ISE Cyber Security Index utilizes a rules-based investment methodology to select a diverse group of companies actively engaged in the cyber security industry.
Index constituents are either classified as infrastructure providers or service providers. Infrastructure providers are focused on creating hardware and software security solutions while service providers generally deliver consulting services and advice. The index contains securities from several countries, a wide variety of market capitalizations, as well as a diverse group of technology sub industries. The rebalance of the index occurs semi-annually and the weighting scheme utilizes a modified equal weight approach. To view the complete index methodology and underlying holdings, please visit ise.com/cyber.
ETFdb: What’s the appeal behind accessing this corner of the market via the ETF wrapper?
CM: Convenience, transparency and intra-day liquidity are three potential benefits to HACK, the world’s first cyber security ETF. The convenience of accessing a basket of cyber security companies diversified by market capitalization, sub-industry and country is significant. An investor would have to make and pay for many trades to achieve what one investment in HACK delivers. Second, the transparency of HACK’s portfolio offers investors the ability to know what they own. This allows for better overall portfolio construction and risk monitoring.
Finally, the intra-day trading of HACK allows investors as much liquidity as a stock. This is important as short-term, event-driven opportunities can arise in cyber security companies due to the headline nature of cybercrime.
ETFdb: How might HACK fit into a portfolio for someone who already owns a broad-based technology ETF?
CM: One of the premier benefits existing broad-based technology ETF investors may experience from HACK is increased diversification. Specifically, when comparing HACK’s portfolio weightings to broad-based technology ETFs like XLK or QQQ, the overlap in portfolio weightings is less than 5%. That means that HACK provides investors with exposure to many technology companies that they don’t own today.
In addition, unlike some types of technology companies that are primarily fueled by discretionary spending, cyber security spending is becoming non-discretionary due to its essential nature. This form of spending may provide additional defensiveness to the underlying businesses of cyber security companies when compared to the business models of the overall technology universe.
ETFdb: Broadly speaking, what are some of the biggest tailwinds you see for this asset class? What are some challenges that pose headwinds for companies in this space?
CM: Tailwinds for cyber security companies are numerous. From a macro standpoint, the increased usage and reliance on digital networks and data by governments, corporations and individuals is fueling stronger demand for protection against cyber threats. While demand for protection in the form of software and hardware is growing, so is the amount of cybercrime. It is almost impossible for cyber security measures to keep ahead of the targets produced by the ever-changing device and software landscape. For this reason, cyber security companies will continue to expand their offerings and solutions.
While the dynamic of demand for increased cyber security measures bodes well for cyber security companies, it does not come without business challenges. Considerable investment into research and development is required in order to be as proactive as possible. In addition, the wide variety of global cyber crime perpetrators–from individuals to government entities–poses a unique set of business challenges. Finally, despite public perception that cyber security is all about outside threats, evidence exists that internal threats like misuse of equipment or poor training of users can be just as problematic. Lack of proper usage and maintenance by cyber security solution users is a potential headwind that providers must address.
The Bottom Line
Granularity has become somewhat of a staple in the ETF industry; that is to say, for every broad-based product out there, investors can generally find a number of more granular options that deliver targeted exposure to a particular corner of any given sector. As such, HACK presents itself as a very compelling investment vehicle for anyone looking to focus on companies engaged in battling cyber crime; while this ETF may be too granular for some, its hyper-targeted nature makes it a great fit for anyone with a bullish outlook surrounding the rapidly growing cyber security industry.
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Disclosure: No positions at time of writing.