XLC - VOX: The Gray Area Of Communication Services

2024-01-18 12:05:14 ET

Summary

• Vanguard Communication Services Index Fund ETF Shares holds a group of high-quality communication services stocks but suffers from a top-heavy portfolio concentration.
• The VOX fund has underperformed the alternative XLC ETF historically.
• While we expect communication services stocks to perform well over the long run, VOX may not make sense for most investors to hold given its limited diversification potential.

The Vanguard Communication Services Index Fund ETF Shares ( VOX ) offers targeted exposure to U.S. stocks as a sector-specific exchange-traded fund, or ETF. On this point, while "communications" play an increasingly important role in a world that is more digital than ever, the definition of the companies representing the group has become more difficult considering an overlap of themes across technology, telecommunications, and even consumer discretionary.

Indeed, we make the case that the communications sector has lost some of its focus as a unique market segment, considering the leading stocks fall into a gray area of classification.

So while VOX performs as intended, we find some weaknesses in its structure that limit its attraction as an investment vehicle for investors. Ultimately, the fund is top-heavy in terms of portfolio concentration, with many stocks only sharing a loose connection to high-level sector performance drivers.

What is the VOX ETF?

VOX technically tracks the "MSCI US IMI Communication Services 25/50 Index" covering large to small-cap stocks in the U.S. equity universe. For reference, the 25/50 qualifier in the index names reverse to a 25% cap on an individual holding, while stocks with a weighting above 5% cannot exceed 50% of the total index and fund allocation.

Within the sector classification, companies that provide telephone, data transmission, cellular, and wireless communication services and offer related content and information distribution through various media formats are included.

Vanguard breaks this down by subsector, with "interactive media & services" representing 49% of the fund, while "movies & entertainment" is the next most well-represented at 15% of the fund exposure.

VOX Portfolio

Going through the list of current VOX holdings, what stands out are the large positions in Meta Platforms, Inc. ( META ) and Alphabet Inc. ( GOOGL , GOOG ), which combined have a 44% weighting.

Naturally, this size allocation is consistent with the market-cap weighting methodology, considering these are among the biggest companies in the world by market value.

Their positions have an outsized influence on the fund return and risk profile. That would be our first knock on VOX, as this level of exposure into just two companies nearly defeats the purpose of an exchange-traded fund. META and GOOGL may be great stocks, but with a very bullish view on either, it may make more sense just to hold each name individually.

Down the list, we find Verizon Communications Inc. ( VZ ), Netflix, Inc. ( NFLX ), The Walt Disney Co ( DIS ), The Trade Desk, Inc. ( TTD ), Roblox Corp ( RBLX ), and Live Nation among the top holdings.

Here we can highlight this relative diversity within the sector where stocks like VZ or AT&T Inc. ( T ) are the prototypical telecommunications name, but have a very distinct profile to a social media player such as Snap Inc. ( SNAP ) or gaming leader like Electronic Arts Inc. ( EA ).

The point here is to say that while all of these stocks are in the "communications sector," it's clear that company-specific fundamentals and operating trends are more important to their equity price performance than a single overriding sector theme.

As many of these companies become larger and larger, their business purpose crosses over into various sectors. A strong case can be made that Alphabet would find a home in the "tech" sector, the same way Apple Inc. ( AAPL ) could also be considered a communications services player given its media platform and growing advertising business.

This is different compared to other core sectors like financials, where underlying banks and insurance names share similar macro drivers. The energy sector, as another example, includes oil and gas stocks that face the same commodity pricing trends.

By this measure, communication services have a vague scope that makes it difficult to work as a unified ETF and limits its appropriateness as a portfolio holding for most investors. That's the gray area of the sector that makes VOX elusive in finding its purpose.

VOX vs. XLC

One idea that could make sense to hold VOX would be in consideration for exposure to META or GOOGL with the added diversification of the "other 115 stocks."

We can bring attention to the alternative Communication Services Select Sector SPDR® Fund ETF ( XLC ), which is similar to VOX with its sector-specific objective, but in this case, includes only the stocks within the S&P 500 Index (SP500). Keep in mind that both funds feature a low-cost 0.10% expense ratio.

The result is that XLC has an even more concentrated portfolio with just 23 holdings, and the exposure to META and GOOGL/GOOG represent 48% of the fund. That dynamic has allowed XLC with a 15% total return over the last 3 years to materially outperform the 3% gain from VOX over the same period, in large part from the META and GOOGL weightings which led the sector higher in 2023.

In this regard, investors seeking to use a communications services ETF for that particular "META/GOOGL plus" exposure combination may be better served by holding XLC over VOX.

At the same time, VOX may have the advantage of the marginal level of diversification that would limit the downside in a scenario where META and GOOGL end up underperforming over any particular timeframe.

Another option is the Invesco S&P 500 Equal Weight Communication Services ETF ( RSPC ), which we believe better captures the spirit of a sector-targeted fund, by systematically reducing the importance of META and GOOGL in its exposure.

In this case, while RSPC has underperformed both VOX and XLC over the last several years, its relative tilt away from the "mega-caps" could be better positioned to outperform the upside in the next stage of the bull market.

What's Next For VOX?

Communications services sector companies are otherwise well positioned to benefit from a continuation of resilient economic conditions and underlying market growth. From a high-level macro perspective, a building consensus for Fed rate cuts through 2024 is seen as both kickstarting a new economic growth cycle while also supportive of valuation multiples.

Any forecast for VOX will need to start with an outlook for Meta Platforms Inc. and Alphabet Inc. A theme for both companies over the past year has been renewed earnings momentum while generating financial efficiencies and working to expand profit margins. The emergence of artificial intelligence as a new growth driver has added to the bullish sentiment for the group expected to continue going forward.

The good news here is that among mega-cap market leaders, META and GOOGL appear to trade and reasonable valuations with a forward P/E around 21x, both well below their historical averages.

If we can point to areas of the market that appear "expensive," it won't be communications services stocks which include several names that remain beaten down compared to their pandemic-era cycle highs. We sense that there is good relative value in the sector overall.

The risk here is that conditions begin to diverge from that same market baseline. An environment where economic growth deteriorates or interest rates remain higher for longer could represent renewed market volatility to communications services sector stocks would not be immune.

Final Thoughts

The communications services sector is "fine" and we expect VOX to deliver positive long-term returns. That being said, we don't recommend the fund given what we believe are shortcomings in its structure making it difficult to fit in within the context of a broader equity portfolio.

In our opinion, Vanguard Communication Services Index Fund ETF Shares includes many high-quality stocks but fails to build a case as a compelling stand-alone ETF given its composition. Investors that have a large position in a tech-heavy index fund covering the Nasdaq 100 like Invesco QQQ Trust ETF ( QQQ ) or even broad market ETF such as the SPDR® S&P 500 ETF Trust ( SPY ) will essentially be overweighting META and GOOGL with only a marginal diversification benefit.

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