TELECOM ETFs
Despite the sluggish economy, stiff competition and stringent regulations, the U.S. telecom service providers are delivering consistent growth making it attractive for investment The industry is heavily weighted towards innovations and technological changes as both the wireless and wireline markets have become saturated.
Several industry researchers from Global Industry Analysts Inc. (GIA) estimate that the market size of the global telecommunications industry might reach $1.8 trillion in the next three years. The U.S. telecommunications industry will continue to hold the largest share of it. According to market research.com, U.S. telecom revenue is expected to grow about 3.9% per year to reach approximately $1.2 trillion by 2020 from the current $750 billion.
Growth Opportunities
Majority of the future growth of the telecom industry depends on the wireless business as subscribers are discontinuing landlines and moving quickly to wireless connections. The present wireless market is ready for the on-going boom in the wireless data space with the growing broadband services.
The demand for data traffic is growing in leaps and bounds and has more than doubled over the last three years. Although the carriers are facing hurdles in managing the rising mobile data traffic amid stiff competitive pressures and limited wireless spectrum licenses, it is creating new growth opportunities for them. These include IPTV offerings, cloud computing, video conferencing, online video telecom streaming and managed telepresence.
Carriers like Verizon Communications Inc. (VZ), CenturyLink Inc. (CTL) and AT&T Inc. (T) are rapidly entering into the cloud computing space, which is now a business prerequisite that is high on demand. The global cloud computing market is currently estimated at approximately $37 billion and is expected to hit $121 billion by 2015 at a growth rate of approximately 26% per annum. Major players such as Apple Inc. (AAPL) and Google Inc. (GOOG) are gaining increased traction, and are enabling the developments in mobile cloud computing. Additionally, managed telepresence services are gaining popularity and are expected to reach market capitalization of approximately $1.5 billion by 2016, with an annual growth rate of approximately 25%.
Further, smartphones, in particular iPhones and Android-based handsets, tablets and 4G LTE are facilitating the companies to boost market share over the next several years. As the smartphone market is growing rapidly, companies are progressing fast to acquire more spectrum licenses to meet the explosive growth of Internet-connected smartphones and tablet computers. As a result, the US Congress eased spectrum access last month for next generation wireless networks, which would expand data services to a greater number of customers.
Besides, the LTE deployments will allow the global carriers to take advantage of the new and unused spectrums while expanding their abilities to deliver the strongest and the most advanced networks. In addition, enhancing network capabilities will lead to creation of new opportunities, economies of scale and will open up markets that were previously inaccessible.
We believe the ongoing developments and inventions aimed to upgrade the existing network infrastructure would boost wireless growth prospects in the years ahead.
Threats
Continued expansions and obtaining wireless spectrum licenses have prompted huge investments. Most of the investments were directed towards technological updates, entering new markets, and enhancing capacity into the existing markets having poor standards of service quality. As a result, telecom companies may be exposed to high debt levels and limited liquidity, which puts a premium on sustainable cash flow to service debt obligations.
Additionally, telecom U.S. operations are subject to regulations by the Federal Communications Commission and other federal, state and local agencies. The 4G infrastructure, which has become the principal next-generation global standard, may be an obstacle if other service providers shift to different generation technologies.
Telecom ETFs
As telecom sector is expected to outpace the economy in future, investors seeking solid returns on their investment might consider telecommunications industry Exchange Traded Funds (ETFs).
Telecom ETFsallow investment in a basket of telecommunications companies, which has a significant stake in telephone and internet products, services and technologies. There are three types of telecommunication ETFs.
Telecom services ETFs reflect the bunch of companies providing phone and internet services.
International telecom ETFs includes top telecom companies from countries around the world.
Other telecom ETFs track the sector as a whole and do not focus on a single aspect of the telecommunications sector.
Overall, there are nine ETFs in the telecom space and let us analyze them one-by-one.
Telecom Services and Other Telecom ETFs
Vanguard Telecommunication Service ETF (VOX) tracks the Morgan Stanley Capital International (MSCI) US Investable Market Telecommunication Services 25/50 Index. Introduced in September 23, 2004, the ETF holds 36 stocks that provides wireless, high-speed, fiber-optic cable, fixed-line and cellular services, with 71.81% concentration in top 10 companies. Top holdings include Verizon (24.09%), AT&T (23.30%) and Crown Castle International (4.53%). The total assets as of March 5, 2012 were $431.2 million. This ETF has a below average expense ratio of 0.19% compared to its category average of 0.47%. The fund generated 0.25% return over 1-year period (as of February 29). This has outpaced 1-year index return of 0.12%.
iShares Dow Jones U.S. Telecom (IYZ) tracks the performance of the US wireline and wireless telecom stocks as represented by the Dow Jones U.S. Select Telecommunication Index. The fund invests 69.83% in top 10 holdings with the largest concentration in AT&T (17.08%), Verizon (12.92%) and CenturyLink (8.21%). It charges slightly higher 0.48% compared to category average of 0.47%. The total assets as of March 5, 2012 were $575.7 million representing 30 holdings. The ETF has underperformed its benchmark over the past year with annualized returns of 0.41% (as of March 12) as compared to the index return of 0.82%.
Focus Morningstar Communication (FCQ) tracks Morningstar Communication Services Index. The fund consists of 35 internet services provider companies with $5.1 million of assets under management, as of March 5, 2012 and charges low fees of 0.19%. The largest holdings are AT&T, Verizon and Comcast with 18.91%, 12.04% and 8.46% of assets, respectively. FCQ, launched on March 30, 2011, has outperformed its index (7.45% returns), producing substantial 8.58% returns since inception.
First Trust NASDAQ CEA Smartphone (FONE) tracks NASDAQ OMX CEA Smartphone Index. It seeks investments in companies including telecom service providers, vendors and manufacturers that are engaged in smartphone activity. Initiated in February 17, 2011, the fund holds 69 stocks (asset value $14.8 million as of March 5, 2012) with expenses ratio of 0.70%. The top three holdings include Benchmark Electronics (3.13%), Sanmina-SCI Corp (3.08%) and Wistron Corp (3.01%). Since its launch in February 17, 2011, the ETF has yielded negative 13.01% return compared to the negative 12.30% index return.
SPDR S&P Telecom ETF (XTL) seeks to match the returns and attributes of the S&P Telecom Select Industry Index. Initiated in January 26, 2011, the fund has 58 holdings with total asset value of $6.8 million (as of March 5, 2012) and expense ratio of 0.35%. The top 10 holdings include Level 3 Communications, Leap Wireless, Harris Corp, Polycom, Finisar Corp, Ciena Corp, MetroPCS Communications, JDS Uniphase Corp, Crown Castle and Tw Telecom each having uneven concentration in the range of 2.3%-2.6% of assets. The fund had underperformed its benchmark with negative returns in one-year period (as of February 29).
International Telecom ETF
iShares S&P Global Telecommunication (IXP) tracks the performance of global telecommunication market and includes diversified and wireless communications companies. It replicates S&P Global Telecommunications Sector Index and consists of 48 holdings with assets of $423.7 million as of March 5, 2012. Approximately 68.03% of funds were allocated to the top 10 holdings. The three largest ones are AT&T, Vodafone and Verizon with 16.25%, 12.17% and 9.68% weights respectively. The fund has substantial global exposure with 30.46% in United States, 14.77% in United Kingdom, 7.90% in Japan, 6.25% in Canada, 6.22% in Spain, 5.20% in Mexico, 5.17% in France 8.70%, 4.99% in China, 4.05% in Australia, 3.17% in Germany and 11.82% in other countries. The ETF has an average expense ratio of 0.48% compared to its category average of 0.47%. The fund yielded a 1.22% return in 2011 compared with index return of 1.13%.
SPDR S&P International Telecommunication (IST) tracks the performance of S&P Developed Ex-U.S. Broad Market Index (BMI) Telecommunication Services Sector Index. The index consists of non-US telecom companies in developed and emerging markets having market capitalization of at least $100 million. The three largest holdings of top 10 stocks (64.21% of total assets) include Vodafone, Telefonica and Deutsche Telekom with 21.27%, 10.69% and 5.43%, respectively. The fund is broadly diversified across many countries – United Kingdom with 27.29% weightage, Japan 14.29%, Spain 10.69%, France 8.70%, Canada 6.27%, Germany 5.66%, Sweden 3.77%, Singapore 3.29%, Italy 2.84%, Netherlands 2.53% and other 14.67%. The total assets as of March 5, 2012 were $14.7 million representing 61 holdings. The fund’s expense ratio is 0.50%. The ETF produced a negative annualized return of 7.49% (as of February 29) compared with the negative 6.81% index return.
iShares MSCI ACWI ex US Telecom (AXTE) tracks the MSCI All Country World ex USA Telecommunication Services Index. The fund includes 93 non-US telecom stocks, which are readily available for trading in developed and emerging markets with 54.17% concentration risk in top 10 companies. The total assets as of March 5, 2012 were $2.66 million. Top holdings include Vodafone (15.04%), Telefonica (7.81%) and China Mobile (7.15%). Country wise, the fund is exposed to United Kingdom (18.30%), Japan (10.43%) and China (9.64%), and lesser extent to South Africa (4.10%), Germany (3.61%) and Singapore (2.81%). The fund’s expense ratio is 0.48%. The fund (-2.17% return) had underperformed its benchmark (-1.83% return) in 2011.
EGShares Telecom GEMS ETF (TGEM) comprised of top telecom stocks of the emerging markets represented by Industry Classification Benchmark (ICB). The fund is exposed more to China, Brazil, South Africa, Malaysia and Mexico. It was launched in June 23, 2011, and had total assets of 2.0 million as of March 5, 2012. The top three holdings include China Mobile (10.66%), America Movil (9.49%) and MTN Group (7.35%). The ETF charges fees of 0.85% and currently has 27 holdings. The fund has generated solid returns of 10.76% since inception and has outperformed the index returns of 7.45%.
Recommendation
Of the nine ETFs discussed above, we would recommend FCQ. Though bid-ask spread is little bit higher, the fund charges extremely low fees, trades in large volumes and outperformed its index year-to-date. FCQ represents the basket of stocks that provide internet services such as access, navigation and internet related software and services. The demand for broadband internet services including video streaming and cloud computing is riding high, which will boost subscriber accretion and improves churn rate (customer switch). This would ensure higher returns in the medium to long-term.
Although VOX delivered lower returns of less than 1%, we expect the fund is attractively valued at current levels. Trading in good volumes, the fund involves less cost of investment given low expense ratio and bid-ask spread. It is the most diversified representing the stocks of large, medium, and small U.S. companies. These companies offer fixed-line, cellular, wireless, high bandwidth, and fiber-optic cable services. Hence, if the performance of any particular service will decline, the fund will likely be benefit from other services included in the portfolio. So, we consider this the best fund after FCQ.
In the international telecom ETFs, IXP looks attractive to us at current levels given its low bid-ask spread and lower fees compared to the other products in the space. It is highly traded and is expected to deliver higher returns as the fund has a greater exposure to developing markets, where the telecom industry is growing rapidly. Although TGEM has delivered highest return, its expense ratio is the highest of all other telecom ETFs.
