Comprehensive Guide To Software ETF Investing

The health of the global economy, especially in developed markets, is largely dependent on technology, which is driven by innovation and expertise. The tech industry is the cluster of software and services, technology hardware and equipment, and semiconductors and semiconductor equipment. Currently, this segment accounts for more than 20% of the S&P 500 benchmark. (Read: Three ETFsTo Play The Tech IPO Boom)

As the digital age dawns on us, the future of tech business appears more reliant on software than equipment. In this segment, companies like SAP AG (SAP), Oracle Corporation ( ORCL - Analyst Report ) , International Business Machines Corporation ( IBM - Analyst Report ) and Microsoft Corporation (MSFT) are leading the global technology industry.

In fact, the global software industry has bounced back from a stagnant 2010, with a growth of 8.2% to $267 billion in 2011. Furthermore, according to research and markets analysts, the industry is expected to reach $358 billion in 2015 and $462 billion by 2020.

Software development is now a key portion of modern technology. The number of software applications has taken technology to new heights. This corner of the market is seeing robust growth with a wide variety of products and services, especially with SaaS (software-as-a-service) applications.

Additionally, rapid expansion of the internet in developing markets, as well as the incredible growth of internet connected devices have helped to keep software and related services in demand despite slowdowns in other sectors of the economy. Now, with the emergence of cloud computing worldwide, further growth could be had in the software market in the future as well (Read: Inside The Cloud Computing ETF (SKYY)).

Currently, the global software market is dominated by China, the world’s second largest economy, followed by India. A large Internet and mobile phone user base in these countries has helped spur increased demand for software and related services and looks to continue to be a source of profits for the industry in the coming years, even if a broad slowdown afflicts these nations.

Thanks to these trends and the relatively solid outlook for the tech industry, investors may want to consider this corner of the market over the broad tech space. For investors seeking to play in this sector, there are currently three ETFs, all targeting the North American market which could make for excellent picks:

iShares S&P North American Technology-Software Index Fund (IGV)

This ETF is a passively managed fund and targets the U.S. software market. It seeks to replicate the price and performance of the S&P North American Technology-Software Index, holding 54 securities in total.

With AUM of $574.0 million, the fund offers exposure to software companies that produce client/server, enterprise, Internet, PC and entertainment software. Since the fund focuses on a particular sector, it has limited scope and lacks diversification benefits.

The product allocates the majority of its asset (roughly 58%) to top 10 holdings, with Microsoft Corporation (MSFT), Salesforce.com Inc. (CRM) and Oracle Corporation ( ORCL - Analyst Report ) being the top three. Since the fund consists of all cap stocks, it has generated excellent returns of 11.68% year-to-date (Read: Three Technology ETFs Outperforming XLK).

The product also trades with good volume and is relatively inexpensive charging 48 basis points a year. However, investors should note that the product does have a meager 0.04% dividend yield suggesting it won’t be much of a source of current income.

PowerShares Dynamic Software Portfolio (PSJ)

Launched in June 2005, PSJ is designed to provide capital appreciation or returns of the U.S. software stocks. With total assets of $47.7 million, the fund is a more volatile and less liquid ETF in the software space and tracks the Dynamic Software IntellidexIndex.

The stocks in the fund are evaluated on good investment merits such as price momentum, earnings momentum, quality, management action and value. The ETF uses a full replication strategy, holding all 30 stocks in the index.

The product puts about 42% of its assets in the top 10 companies. Its top three holdings are Cerner Corporation (CERN), Activision Blizzard Inc. (ATVI) and Intuit Inc. (INTU).

The fund focuses primarily on companies that are engaged in the research, design, production or distribution of products or processes related to software applications and systems, and information-based services. (See more ETFs in the Zacks ETF Center)

This ETF is appropriate for investors seeking broad exposure to the U.S. software market with a focus on all cap equities. The product is a high cost choice in the tech space as it charges 63 bps in fees per year. However, the fund has produced an impressive return of 9.34% year-to-date but does not distribute dividends.

SPDR S&P Software & Services ETF (XSW)

Investors seeking exposure to all types of software services including application software, data processing and outsourced services, home entertainment software, Internet software and services, IT consulting, and systems software may find State Street’s XSW an interesting option.

The product has total assets of $17.9 million under its management and holds 137 securities in its basket. It puts less than 10% of assets in top 10 holdings in equal weights of roughly 1% each, and is therefore, widely spread across various companies. The top three companies are AOL Inc. (AOL), Liquidity Services Inc. (LQDT) and Ariba Inc. (ARBA).

The fund seeks to match the performance of the S&P Software & Services Select Industry Index, which is the subet of the S&P Total Stock Market Index. The fund does not fully replicate the underlying index, and include cash and cash equivalents, money market instruments and securities, which are not included in the index (see Three Great Tech ETFs That Avoid Apple).

Small companies make up more than 50% share in the fund while the large and medium companies take the remaining portion. The product is less liquid, less volatile, and trades with a small volume, roughly 4,000 shares per day.

However, XSW is cheap relative to the other two ETFs in the software space. It charges a paltry fee of 35 bps a year. The product has delivered good returns of 6.26% year-to-date but yields an annual dividend of only 0.05%.

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