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Are Telecom ETFs In Trouble?

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Although the American economy appears to be picking up steam, earnings reports in some industries have failed to keep pace. A variety of bellwethers have either failed to beat estimates or have suggested to analysts that future growth and income could be curtailed. Recently, investors saw this trend on display again in the telecom space in the case of Verizon Communications (VZ - Free Report) .

The firm saw adjusted earnings of 52 cents per share but fell below the Zacks Consensus Estimate by one cent, helping to push the stock lower immediately following the release.  Additionally, the stock currently has a Zacks Rank of 4 (Sell) and the broad communication services sector is among the worst rated industries in Zacks Industry Rank terms. Thanks to these factors, as well as the recent performance of the space and the intense competition, the outlook isn’t exactly bright for the sector over the next few months.

As a result, it should be no surprise to some investors to see that a few U.S.-focused telecom ETFs such as the iShares Dow Jones US Telecom ETF (IYZ - Free Report) , have been underperforming their broad market counterparts such as SPY. In fact, over the past three month period, IYZ has fallen by 0.75% while (SPY - Free Report) has gained close to 4.7% suggesting that telecom firms are struggling to keep up with the rest of the market. Given the low Ranks on many of the firms in the space as well as the low Zacks Industry Rank, one has to think that this trend could certainly continue in the near term as well (read Three Low Beta Sector ETFs).

However, while the most popular U.S. telecom-focused ETF has been seeing weakness, it has not really extended across the sector into the other funds in the space. For example, of the rest of the ETFs in the sector—, (XTL - Free Report) , and (VOX - Free Report) —two have actually turned in positive performances over the past three month period while VOX has actually slumped more than (IYZ - Free Report) . While this might be initially perplexing given the similar focus of all of these funds, a closer look at the holdings reveals some key differences among these ETFs (see Three Tech ETFs Outperforming XLK).

First, investors should note that IYZ, a fund with over half a billion in AUM, puts close to 38% of its assets in three companies AT&T (T - Free Report) , Verizon (VZ - Free Report) and CenturyLink (CTL - Free Report) .  Given the heavy concentration in these securities, and the fact that none of these stocks have a Rank better than 3, it shouldn’t be surprising to see that this product has been a big loser in the past three months. A similar issue is impacting VOX and leading to its heavy underperformance in the space as well. This fund puts close to 50% of its assets in VZ and T, leaving very little for a variety of other companies. Since VZ has lost close to 5.8% in the past month alone, VOX’s performance was sure to follow as it is hard to buck the trend of nearly one-fourth of a highly correlated portfolio (read ETFs vs. Mutual Funds).

Meanwhile, on the winning side, both FCQ and XTL have a much more liberal definition of telecom firms, a factor which has allowed them to greatly outperform in recent months. First, FCQ, which has added 2.1% over the past month, also has heavy weightings to T and VZ, as these securities make up nearly one-third of total assets. Yet, beyond these two securities, companies such as Comcast (CMCSA - Free Report) and DirecTV round out the top four, ensuring that the same issues that are plaguing major providers of wireless services—like iPhone subsidies and increased data usage—do not impact the entire portfolio of the fund. Thanks to this inclusion of cable and internet providers the fund has been able to skirt by much of the turmoil in the wireless communications sector, making it a better pick for some over the time period (see Top Three Consumer Staples ETFs).

Lastly, there is the example of the newcomer, SPDR’s S&P Telecom ETF (XTL - Free Report) . This product tracks the S&P Telecom Select Industry index which seeks to represent the telecommunications sector of the S&P total market index.  While this is very similar to the first two examples, there is one key difference; XTL uses a modified equal-weight methodology. This distinction means that of the fund’s 60 holdings, no one company makes up more than 2.5% of the total. As a result, VZ and T combine to make up under 5% of total assets, giving the product a much more diversified focus across a variety of sectors and smaller cap firms.

Thanks to this key difference, XTL has gained nearly 8.3% in the past three months, a pretty remarkable feat considering the rest of the space lagged the market and that SPY only added about 4.7% in comparison. This should once again show investors that many times, the most popular ETF isn’t the best performing and that outsized returns can be had by looking at smaller, less popular products in the space.  Additionally, the weighting structure and benchmark of a fund really does matter as we can see in this telecom ETF case as the difference between the best and worst performers was close to 600 basis points over just a three month period.

However, it should also be noted that XTL will not always outperform its counterparts in the space and that IYZ and VOX are not destined to lag. Instead, IYZ and VOX should be thought of as better plays when large caps are surging while FCQ could be a better choice for those uncertain of the broad outlook and want more diversification in the space. On the other hand, XTL is probably the best bet for when small caps are surging and the big names in the industry—like VZ and T—are experiencing weakness, as they are now (read Three Outperforming Active ETFs).

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