The current ETF product universe casts a wide net of exposures which makes it more challenging for investors to select from the different options. Every month we will explore a specific area of the market and compare seemingly similar ETFs by getting under the hood to understand how they differ and what this means to potential investors. This month we will explore three popular Technology ETFs so that you can make a more informed decision.

Written by Kim Escue

All three ETFs we are exploring today are passively managed to track a specified technology sector index.

Source: ETF Investment Manager

How They Are Created

The First Trust NASDAQ 100 Technology ETF (NASDAQ:QTEC) attempts to track the investment results of the stocks classified as Technology within the NASDAQ-100 Index. As a result, QTEC is the only one of the three that is equal weighted.

The Technology Select SPDR (NYSE:XLK) seeks to provide similar results to the Technology Select Sector Index, which is comprised of Technology stocks within the S&P 500 Index. This index is modified capitalization weighted by applying a maximum to the weight of a single security in the Index, regardless of its market capitalization. If a stock exceeds the cap, it is assigned a 24% weight in the Index and the excess is redistributed to uncapped stocks equally.

The iShares North American Technology ETF (NYSE:IGM) follows the investment results of the S&P North American Technology Sector Index, which consists of the Technology stocks within the S&P Total Market Index. This Index is also uses a modified capitalization methodology, however, the cap is set at 8.5% and the remaining allocation is proportionally redistributed to uncapped stocks (as opposed to equally redistributed in XLK).

What Investors Should Consider

All three Technology ETFs we are comparing follow an Index that is composed of Technology stocks from a broader Index. In general, the larger the broader Index, the more securities the ETF will hold. While more securities equal more diversification in the names of the stocks held, the weighting methodology determines the concentration of stocks in the top 10% of the underlying portfolio.

The NASDAQ-100 Index is the smallest of the three universes and First Trust NASDQ 100 Technology ETF (QTEC) has the smallest number of holdings. Despite this, QTEC has the lowest individual stock concentration due to the equal weighting methodology used, which results in approximately 30% of assets invested in the top 10 holdings.

The Technology Select SPDR (XLK) has a greater number of holdings (74) due to the larger universe of the Technology stocks within the S&P 500 Index. There is a cap limit of 24% per holding allowed by the Index methodology, resulting in a concentration of the top 10 holdings of nearly 60%.

The iShares North American Technology ETF (IGM) invests within the Technology sector of the S&P Total Market Index, which results in the largest number of holdings of the three options. It also includes the broadest range of market capitalizations (small, mid and large cap). As a result, IGM holds 267 positions and caps the holdings at 8.5% per security, resulting in a top 10 concentration of roughly 50%.

A Look At The Industry Exposure

Another key thing to consider when evaluating sector ETFs is the underlying industry exposures. Technology is a broad sector and what classifies as Technology depends on the index provider. By digging deeper, we can see some important differences across these three technology ETFs.

Source: Bloomberg as of 9/30/16.

From the chart above you can see that QTEC has a much higher concentration to semiconductors than the others. While IGM and XLK have a fairly similar allocation among the industries, their index methodologies define technology differently. For instance, IGM considers the Internet Retail Sub-Industry as part of the Technology Sector, whereas XLK considers Telecommunication Services as part of the Technology Sector.

Source: Bloomberg.

As the chart above illustrates, the differences between these technology ETFs can lead to significant performance variation. These differences are not trivial. QTEC has been the strongest performer of late. Investors will have to determine which of these investments has the attributes that the market will favor going forward. Understanding how the underlying index is constructed and the different exposures it allows for is important for investors trying to express a particular view within the Technology sector.

With the vast number of offerings available, looking under the hood can be a tedious, but important part of the investment process. While we have analyzed three options above, there are many more available to investors. The appropriate ETF for an investor will depend on the underlying exposures and other attributes they seek.