2023-06-16 07:31:35 ET
Summary
- XSW is a unique equal-weighted software ETF that offers diversified exposure to software companies of all sizes, focusing on small-cap companies.
- XSW's focus on small-cap companies stands to drive growth for the fund, as I am bullish on small-cap companies in current economic conditions.
- I rate XSW a Buy. The software and services industry is projected to grow nearly 12% each year from 2023 to 2030.
Strategy
Launched by State Street Global Advisors, Inc. in 2011 and managed by SSGA Funds Management, Inc., SPDR S&P Software & Services ETF (XSW) invests in stocks of companies in the software and services industry. Within this industry, the fund invests in a variety of sub-sectors, ranging across information technology, IT services, IT consulting, application software, and systems software. XSW invests in growth and value stocks of companies across diverse market capitalizations. The fund aims to track the performance of the S&P Software & Services Select Industry Index, using a representative sampling technique. The index is rebalanced quarterly.
Holding Analysis
XSW invests in a total of 156 software and services stocks in the United States, using an equal-weighted approach to allocate weightings for its holdings. The fund primarily uses this approach to reduce concentration in the top companies in the industry. As a result, the fund focuses more on smaller, growth-oriented companies. Unlike most other tech and software ETFs, the top 10 holdings are extremely un-concentrated, only constituting 10% of its entire portfolio. Its top 10 holdings range from weights of 0.85% to 1.23%, providing relatively equal exposure to all 156 companies that XSW invests in. Moreover, XSW also provides equal exposure to all company sizes, allocating 28% to large-cap, 44% to mid-cap, and 28% to small and micro-cap companies.
Strengths
XSW is a unique Software ETF that significantly stands out among its peers. It is the only equal-weighted ETF in a sea of market cap weighted funds. The top 10 holdings of the fund only constitute 10% of its entire portfolio, which is significantly less than all of its peers. Peer funds typically hover in the 45% range, and XSW even stands to have 71% in its top 10 holdings. XSW is extremely diversified and less vulnerable to the poor performance of a few companies. This is also necessary given the large amount of exposure the fund provides for small-cap companies. Moreover, I believe that now is the perfect time to invest in small-cap companies. Regardless of whether an economic recession or recovery is looming, small-cap companies are still poised to outperform large-cap companies in either occasion. While the tech and software industries are definitely experiencing a recovery from a tumultuous 2022 slump, there is also a possibility that the US economy goes into a recession as the FED continues to raise interest rates . However, it may be difficult to accurately demarcate when economies transition between the four stages of the economic cycle as seen below.
Moreover, XSW is extremely liquid compared to its peers with an average daily dollar volume of $2.41 million, which is significantly higher than that of 5 of its peer competitors.
Weaknesses
While the equal-weighted approach may differentiate XSW from its peers and provide a balanced and diversified portfolio, the fund's sector-specific focus in software and services may provide limited appeal to investors who are looking to build a long-term portfolio. The fund definitely mitigates company-specific concentration but not so much sector-specific concentration. XSW provides targeted exposure to US companies in the software and services sector, and this narrow focus does not appeal to investors seeking broader diversification across various other sectors.
Furthermore, the software and services sector can be especially sensitive to economic conditions, as consumers may reduce spending within this sector in uncertain economic times. This can contribute to higher volatility and potential losses during economic downturns, especially for those who do not invest in the fund long term. Therefore, XSW only appeals to a specific niche type of investor with expertise looking to invest in a small corner of the market.
Opportunities
The global software and services industry was valued at over $474 billion in 2022 and is forecasted to grow at a CAGR of nearly 12% from 2023 to 2030. The sector currently accounts for over 30% ($151 billion) of the U.S. consumer technology market in 2023. The sector's growth can be attributed to advancements in the digital therapeutics space. The digital therapeutics space is providing promising solutions to healthcare that can improve patient outcomes and reduce healthcare costs. This emerging market is currently worth $300 million and has significant upside potential. The space was up 25% in 2022, and there is a predicted growth of 19% in 2023.
Furthermore, there is increasing popularity surrounding the use of cloud platforms alongside an increasing demand for cloud-based software solutions, especially among small and medium-sized businesses. XSW stands to especially benefit from this with the fund's heavy focus on small-cap companies. This space is also well-positioned to grow through the rising usage of innovative technologies like blockchain, artificial intelligence, and machine learning.
Threats
With this increase in popularity among cloud-service platforms as many companies shift towards remote work, this provides new opportunities for hackers to attack cloud services that haven't fully protected their platforms with their new developments. In 2020, cloud security breaches constituted 79% of all cyberattacks. In the last two years, this number has risen to 98%. Cloud attacks can have serious consequences for businesses utilizing this cutting-edge technology. The problem is that many organizations may not be aware of the risks and vulnerabilities that come with cloud-based software, and accordingly, may not have sufficient measures to defend against them.
Conclusion
XSW is an equal-weighted software ETF that is differentiated from many of its peer competitors. The fund's investment strategy offers diversified exposure to software companies of all sizes, with a particular emphasis on small-cap companies. In our current economic landscape, I believe that small-cap companies are especially poised to outperform mid-cap and large-cap companies. However, a fund whose top 10 holdings only constitute 10% of the entire portfolio does come with its drawbacks. Despite mitigating company-specific concentration risk, the fund is exposed to sector-specific risk, which can diminish its attractiveness to a wide range of investors that seek broader diversification. Regardless, I rate XSW a Buy, as the software and services industry is projected to grow nearly 12% each year from 2023 to 2030.
For further details see:
XSW: A Distinguished Equal-Weighted Software ETF