Taking Stock: Trades Like A Stock, Tracks Like A Fund, But It's Really An ETF

I'm often asked if there are any good ways to invest in technology outside of mutual funds. There's so much information, I'll need two columns to do the answer justice.

Among the alternatives to technology mutual funds, the most common are Exchange Traded Funds (ETFs), an index-based investment product that buys and sells shares of entire portfolios of stock in a single security. These products combine the opportunities of indexing with the advantages of stock trading.

Investing in ETFs offers many benefits. You get to own an entire portfolio of stocks by buying a single security. This lowers the overall cost of ownership by reducing transaction costs. Investors can also use these securities for margin eligibility, unlike mutual funds.

There also are disadvantages. The first major issue is the large number of choices. There are so many ETFs that investors may have trouble distinguishing which ones are right for them.

Here are some ETFs that could be considered as proxies for technology:

Triple Qs, otherwise known as the Nasdaq 100 Index (QQQ), is the best-known ETF. This index measures the average performance of a broadly diversified group of stocks traded on the Nasdaq Stock Exchange. It includes the stocks of 100 of the largest and most actively traded nonfinancial companies listed on the Nasdaq. The biggest disadvantage is that the QQQ may invest too broadly for most technology investors. The index includes companies such as Bed Bath & Beyond, Costco, Starbucks, and USA Networks, as well as several health-care stocks, including biotechnology and medical products. If you're looking for an IT-related proxy, this may not be it.

QQQs are the most actively traded of all these funds, with a 10-day trading average of 76 million shares. The top-10 holdings are filled with obvious names: Microsoft makes up 11.04% of the index, followed by Intel (7.12%), Cisco (4.47%), Qualcomm (3.78%), Oracle (3.3%), Amgen (2.35%), Dell (2.35%), Maxim Integrated Products (2.17%), Immunex (1.78%), and Applied Materials (1.66%).

The Select Sector SPDR Fund is the third-most-liquid ETF as measured by trading volume. It's third on the list for 10-day trading averages with 1.9 million shares, behind the QQQs and the Semiconductor HOLDRS. It's a broad index that tracks the Technology Select Sector Index (IXT). With 98 companies in the portfolio, it's well-diversified among numerous subsectors within technology. SPDR's top-10 holdings are Microsoft (14.87%), IBM (8.66%), AOL Time Warner (7.96%), Intel (7.42%), Cisco (4.81%), Oracle (3.85%), AT&T (3.60%), Dell (2.62%), Texas Instruments (2.36%), and AT&T Wireless (2.36%).

These 10 holdings make up 58.19% of the fund. The biggest component of the index is computer software and services, at 22.65%; the smallest is semiconductors, at 2.03%.

The Semiconductor HOLDRS, which is made up of 20 semiconductor-related stocks, is the second-most-liquid ETF. Its top holdings are led by Intel (23.22%), Applied Materials (13.23%), Texas Instruments (12.97%), Micron (7.09%), Maxim Integrated Technologies (6.21%), Analog Devices (5.87%), and Xilinx (4.69%). These make up 73.28% of the total index. One could reasonably assume that Intel, Applied Materials, and Texas Instruments are almost the proxy for this index. The 10-day average trading volume for the Semiconductor HOLDRS is 3.9 million shares.

The first lesson a technology investor should have learned by now is that ETFs aren't straightforward. Second, they aren't necessarily the types of companies you may wish to invest in. Third, investors may be surprised how much the indices are affected by just a few stocks. In many cases, you aren't getting the broad sector exposure you may be looking for. Bet you can't wait for Part 2.

William Schaff is chief investment officer at Bay Isle Financial Corp., which manages the InformationWeek 100 Stock Index. Reach him at [email protected].