Equity: U.S. Software
The US software segment is one in which the neutral market cap-weighted portrait of the industry doesn't make very much sense in ETF form. After all, a fund that wanted to accurately
“Neither fund comes close to market-cap-weighted representation” mimic the software landscape would have to invest over 70% of its portfolio in Microsoft and Oracle alone, raising serious concerns over concentration risk. Investors interested in such a fund might be better served by just buying Microsoft and Oracle and calling it a day.
The two competing US software ETFs use drastically different methods to solve this problem and create diversified portfolios of software companies. XSW solves the concentration problem by employing an equal-weighting scheme—rather than market-cap weighting—which reduces the aggregate weight of heavyweights Microsoft and Oracle to less than 2%. Meanwhile, PSJ uses a quantitative model to select its portfolio securities then weights them in tiers.
Despite their different selection methods, both funds necessarily tilt toward smaller growth companies and allocate a significant portion of their portfolios to IT services & consulting companies. Costwise, PSJ charges nearly twice as much as XSW does (0.63% vs. 0.35%), making XSW the easy choice for cost-conscious investors. Neither fund is particularly liquid either, so traders will need to exercise caution in both.
A good third option exists outside the segment: the iShares North American Technology-Software Index Fund (IGV). Despite its slightly broader geographic focus (US & Canada), IGV provides more accurate sector exposure to the US software industry than either of the US software ETFs, and trades with far greater liquidity. So, if you don’t mind a few Canadian equities in your portfolio, check out IGV. (Insight updated 04/21/17)
ETF.com Efficiency Insight
XSW edges out PSJ in Efficiency, largely due to its significantly lower expense ratio. PSJ's high fee creates a built-in hurdle to tracking: The fund's median performance lag over
“PSJ's high fee creates a built-in hurdle to tracking” a rolling 12-month period was higher than its headline fee, and far more than XSW’s tracking. Unlike XSW, PSJ doesn't lend portfolio securities, which might otherwise enable it to claw back some of its fees with lending revenue.
Currently, software ETFs aren’t generating much interest: The two funds in the space don't hold much in assets, split almost evenly between the two. Still, we don’t see any elevated closure risk for either of the funds in the space.
Lastly, XSW loses efficiency points because itpaid out short-term capital gains in late 2012 and 2013. This creates an extra tax liability for investors, and is usually avoidable with proper tax management by the fund. (Insight updated 04/21/17)
ETF.com Tradability Insight
Neither fund in the space is particularly liquid and neither will be suitable for frequent traders. Both funds trade less than $100K in volume most days and average bid/ask spreads are
“Limit orders set around the funds iNAV are strongly recommended” north of 15 bps in both cases. Limit orders set around the funds’ iNAV are strongly recommended to help contain trading costs here.
Fortunately, both funds charge reasonable creation fees and hold liquid US-listed securities which means that block liquidity is strong for both funds: Reach out to a liquidity provider to trade large blocks efficiently. (Insight updated 04/21/17)
ETF.com Fit Insight
Neither XSW nor PSJ fits our cap-weighted benchmark very well. However, our neutral benchmark is essentially uninvestable, at least in a typical ETF structure, so low Fit marks here
“Neither XSW nor PSJ fits our cap-weighted benchmark closely” aren't necessarily bad. After all, our benchmark—which reflects the market—allocates nearly 3/4 of its portfolio to Microsoft and Oracle. Still, both funds broaden their industry exposure beyond pure software.
XSW does this by design—as a software & services fund, XSW includes a significant allocation to services. Meanwhile, PSJ uses the Revere Hierarchy industry classification system, which differs markedly from our benchmark's industry classification system. Despite their differing paths, the end results for both funds are similar: They significantly cut their allocations to pure software companies, while IT services & consulting make up a bigger chunk of their portfolios.
Industry tilts aside, each fund's weighting scheme pushes it further away from our segment benchmark by firm size too. XSW equally weights its portfolio, while PSJ equally weights securities within tiers. Both funds have significant small-cap tilts. Our benchmark has a weighted average market cap of over $200 billion—in comparison, XSW and PSJ are far smaller, with market caps of $14 and $35 billion, respectively.
All in all, investors interested in a broad portfolio of software & services companies will likely prefer XSW, while investors interested in a more selective methodology may prefer PSJ. (Insight updated 04/21/17)