XTL: A Better Telecom ETF?

by on May 17, 2011 | ETFs Mentioned:

ETFs may have been designed with the long-term, buy-and-hold investor in mind, but as the industry has evolved the potential benefits of the exchange-traded structure have been acknowledged and embraced by other types of investors as well. Several ETFs are designed primarily as trading instruments for those who measure holding periods in hours and minutes, while there are hundreds of funds created to be means of implementing tactical tilts or overlays to a broader portfolio.

Among other potential uses, ETFs can be efficient tools for implementing sector rotation strategies, allowing investors to shift exposure across various corners of the U.S. market based on broad macroeconomic trends, pricing metrics, and other valuation factors. There are dozens of sector-specific ETFs that allow investors to achieve exposure to a basket of securities that comprises a specific corner of the economy, and the intra-day liquidity feature allows for nimble movements into and out of positions.

Of course, sector ETFs have a number of other uses beyond pure sector rotation strategies. They can be useful tools for implementing a tactical tilt to fine tune risk exposure, with certain sectors having appeal to those looking to scale back risk and other high beta segments appealing to those looking to chase greater returns. The telecom sector has historically been popular for investors looking for low volatility and enhanced dividend yields, as this corner of the domestic market has been known to pay out a substantial portions of earnings to investors. And for those looking for telecom exposure, no shortage of ETF options are available to them; there are currently ten ETFs in the Telecom ETFdb Category, including U.S., international, and global products [see Three ETFs For Smart Phone Exposure].

Most sector ETFs, including popular telecom funds such as the iShares Dow Jones U.S. Telecom Index Fund (IYZ) and Vanguard Telecom Services ETF (VOX) are linked to market cap-weighted indexes, benchmarks that essentially offer investors a way to own a small portion of the overall market by determining individual allocations based on the size of the companies. While that methodology minimizes rebalancing costs and has certain other advantages, it has the potential to cause significant concentration of holdings. In the telecom sector, which is dominated by a small number of mega cap companies, this effect can be intensified. AT&T (T) makes up about 16% of IYZ (which has about $725 million in assets), while Verizon (VZ) makes up another 12% of holdings. These two telecom giants account for a whopping 45% of VOX, the popular Vanguard telecom ETF that has about $400 million in assets [see all the Telecom ETFs here].

Ticker T Weight VZ Weight Top 10 Weight
IYZ 15.6% 11.7% 68.6%
VOX 22.3% 23.6% 74.1%
XTL 1.9% 1.8% 20.6%

Both of these funds have dozens of other component securities, but the hefty allocations to these two stocks increase the dependence on company-specific developments. Many investors have embraced ETFs because they offer instant diversification to a broad basket of securities; IYZ and VOX deliver access to a basket of stocks, but two of the eggs are noticeably larger than all the rest.

XTL: A Better Option?

Some investors looking to beef up their telecom exposure may be happy with the manner in which IYZ and VOX are structured; they generally reflect the composition of the U.S. telecom industry, and should perform well if T and VZ stock climbs. But for those who want to cast a wider net with telecom exposure, one of the more recent additions to the space may have some appeal. The S&P SPDR Telecom ETF (XTL) seeks to replicate an equal-weighted index that consists of about 65 U.S. telecom stocks. As a result of that methodology, no one name accounts for more than about 2% of the underlying assets, and the ten largest combine to make up only about 20% of the portfolio. T and VZ are included in this ETF, but with approximately the same weighting as lesser-known companies such as Netgear, Polycom, and Powerwave Technologies [see holdings of XTL here].

Similar to other telecom ETFs, XTL offers current return potential and stability. But a comparison of the exposure offered by XTL and IYZ highlights the unique risk/return profiles; XTL makes a far greater allocation to small and mid cap stocks, while including a greater number of component stocks and a smaller allocation to the big names in the portfolio [try the free ETF head-to-head comparison tool].

The comparison of the portfolios maintained by these two funds is further evidence that seemingly similar products often exhibit drastically different risk/return profiles. Asset concentration and depth of holdings are just two of the many factors that are worth close consideration when considering an ETF investment; a relatively quick look under the hood can shed a great deal of light on the merits of an ETF, and a thorough examination of all the ETP options will often lead to a fund that is most appropriate with your specific investment goals.

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Disclosure: No positions at time of writing.