QQQM - IYW: Unique Fund Composition Puts It In Pole Position To Move Ahead Of XLK Again

2024-01-12 03:10:35 ET

Summary

• The first week of trading in 2024 was marked by a sharp pullback in tech stocks, including the iShares U.S. Technology ETF.
• Goldman Sachs believes that the S&P 500 index will perform well this year, particularly the Magnificent 7 stocks.
• IYW's unique fund composition and diversification strategy give it a compelling advantage over its peers.

Investment Thesis

The markets got through the first week of trading this year and going by the price action I saw last week, it's best to sum up the first trading week as a really bad hangover from the party that was 2023. While tech stocks led the way up last year, with the tech-heavy Nasdaq 100 index ( COMP.IND ) rising 43%, it also led the way down in last week's sharp pullback. At the same time, the iShares U.S. Technology ETF ( IYW ) outperformed all major market indices, scoring a 65% gain last year while pulling back 4.2% in its first trading week this year.

However, Goldman Sachs believes that tech stocks will continue to outperform the S&P 500 index ( SP500 ) this year as well, especially the Magnificent 7 stocks. Under the circumstances, I believe the IYW presents a compelling case for capital allocation, given that many fundamentals for technology stocks are projected to get even better on a y-o-y basis in 2024.

About IYW

IYW is owned and managed by the world's largest asset management company, Blackrock, and is part of their iShares umbrella of exchange-traded funds (ETF). The fund offers exposure to technology stocks in the U.S. markets. According to the IYW's prospectus, the fund "seeks to track the investment results of an index composed of U.S. equities in the technology sector."

It achieves this objective by tracking the Russell 1000 Technology RIC 22.5/45 Capped Index, which measures the performance of the U.S. energy sector. The index's unique regulatory framework s tates that all stock components that constitute the Russell 1000 Technology index are capped quarterly so that no single constituent holds more than 22.5% weight in the index. Further, the sum of the weights of all constituents that represent more than 4.5% of the index will not exceed 45% of the total index weight. This immediately introduces the element of diversification in the IYW, which we will cover later.

Still, keeping IYW's overall objective in mind of offering exposure to U.S. technology stocks, the fund competes with a handful of other ETFs that also seek to offer technology sector exposure.

Peer comparison

In the previous section, I explained that diversification is one of the fund's characteristics that separates it from its peers. Before I go deeper into comparing the fund at a holding level, I have compared the IYW to some of the other popular technology-specific ETFs below by looking at some key fund metrics.

To address the elephant in the room, I will note that the fund does have a relatively higher expense ratio compared to its peers. Further, with approximately 780K shares changing hands every day, on average, IYW has a healthy average daily share volume, despite being the smallest fund amongst its peers, by assets managed, as seen above. However, one of the fund's strengths lies in its holdings. As I had pointed out earlier, the fund will automatically achieve diversification in its holdings by virtue of the underlying Russell 1000 Technology RIC 22.5/45 Capped Index it tracks. At the same time, the diversification does not run as wide as the Vanguard Information Technology ETF ( VGT ), for example, which manages 316 stocks. I will also add that I am not a fan of the VGT fund after GICS introduced its framework reclassification. VGT uses the GICS classification to allocate capital towards constituents while also imposing some restrictions, such as restricting capital allocation towards the Communication Services sector. Another fellow Seeking Alpha author has also mentioned this in their SA post while talking about VGT. The Technology Select Sector SPDR ETF ( XLK ) fund also uses GICS classification for its constituents, but as per the chart above, it contains only 66 components.

In terms of performance, it's easy to see how IYW has been a standout winner over the last year.

Fund holdings

I have attached a summary of holdings in IYW below, with the Top 15 on the left and sector allocation on the right.

Technology services constitute 56% of the fund's holdings, while 40% of the fund is electrical technology. The Top 15 funds include some high-quality technology names that draw similarities from competing technology ETFs. I have included a side-by-side comparison of IYW's top 10 holdings vs. its peers and also added Nasdaq's top 10 stocks to the comparison list to illustrate the difference between IYW's top holdings vs. the technology index and its peers.

A couple of observations immediately stand out to me. First, with ~34% of IYW's capital allocated towards Microsoft (MSFT) and Apple (AAPL), the fund can be more closely compared to XLK and VGT than to the Nasdaq Index and hence QQQM. I explained in the previous section how I prefer IYW over VGT and XLK.

Strategic capital allocation benefits

However, on further examination of the IYW's holdings vs. its peers in the chart above, I see another striking observation. Stocks like Accenture ( ACN ), Cisco ( CSCO ), Oracle ( ORCL ), and Tesla ( TSLA ) are notably absent from the top 10 holdings. In fact, Tesla, Accenture, and Cisco are not part of the fund's holdings at all as part of the update after the market closed on January 9th. I see this as an advantage to the fund.

While consensus estimates project Cisco's earnings to decline -4.6% in FY24, Accenture's earnings are expected to rise just 4.5% compared to S&P 500's 11.4% increase as projected by FactSet . On the other hand, consensus estimates peg Tesla's earnings to grow by 20%, which is 1.75 times S&P 500's earnings growth estimates. But at a forward P/E of ~67x, which is 3.4 times S&P 500's forward P/E of ~19.5x, I think Tesla is overvalued. By not including Tesla, Cisco, and Accenture in its fund composition, I believe IYW is positioned for strategic growth by allowing its fund's capital to be allocated toward other growth stocks. Some of the high-quality growth stocks that the IYW fund has allocated capital to are Palo Alto Networks ( PANW ) and ServiceNow ( NOW ). Moreover, another area where IYW wins the capital allocation argument against its funds such as VGT and XLK is that, unlike the previous two funds, IYW can invest in Communication Services stocks such as Meta Platforms ( META ). Meta trades at a forward P/E of just 21x despite consensus estimates projecting Meta's earnings to grow 22% this year, which, according to me, is a bargain for the IYW fund. Given the fund's composition, I strongly think IYW will again be a winner this year as compared to its peers.

Risks to bull thesis

So far, the Federal Reserve's FOMC has indicated that there will be no more rate hikes in 2024. Markets seem to have already digested the FOMC's indications; projecting rates will be cut three times this year. However, if the FOMC were to reverse the course of action and increase rates, it would impact the growth prospects of most technology stocks that are part of all technology ETFs, IYW included. Stubborn inflation could force the Fed to raise rates further.

Another risk that could impact technology stocks that are part of the IYW is the deterioration of the macroeconomic outlook. Any recession or slowdown in the economy would impact spending, whether enterprise or retail, which would hurt the revenue streams of these companies in the IYW.

Finally, specific to the IYW, the fund is slightly overexposed to Microsoft and Apple, which make up ~34% of the fund, exposing the fund to concentration risk. If any one, or worse, both of these stocks' business outlook deteriorates, these stocks will act as deadweights, pulling down the performance of the fund.

Takeaways

To conclude, I believe IYW is in a great position to lead its peers as technology once again is expected to lead markets in 2024. The fund benefits from a relatively superior diversification strategy, positioning it for higher returns in 2024.

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