Cloud Computing Strength Doesn’t Extend to Cloud ETFs

Cloud computing appears insulated from the macro uncertainty that has been plaguing other parts of the economy, based on strong results in the latest earnings reports from the three biggest cloud computing companies in the U.S. 

Year over year, Amazon.com Inc.’s, Microsoft’ Corp.’s and Google’s Alphabet Inc.’s cloud computing units decelerated slightly from Q1 to Q2, but growth held up impressively in the face of all the headwinds facing he economy.  

Revenues for Amazon’s AWS grew 33% year on year in Q2, Microsoft’s Azure grew by 46% and Alphabet’s Google Cloud Platform grew by 36%. 

That those businesses are growing at such rapid rates at their massive scale speaks to how powerful the secular forces propelling cloud infrastructure spend higher are. According to Gartner, enterprise IT spending on cloud computing will overtake traditional IT expenditures by 2025 as more companies embrace the power, flexibility and security of the cloud. 

Underperforming Cloud ETFs 

Unfortunately for ETF investors, the strong performance of the big three cloud computing providers hasn’t extended to the handful of exchange-traded funds that track the cloud computing theme. 

The First Trust Cloud Computing ETF (SKYY), the Global X Cloud Computing ETF (CLOU) and the WisdomTree Cloud Computing Fund (WCLD) are down 30% to 40% on a year-to-date basis. 

That’s partly because to the extent they hold positions in Amazon, Microsoft and Alphabet, those positions are relatively small. On top of that, the cloud exposure those tech giants provide is somewhat diluted by their other businesses—retail in the case of Amazon and advertising in the case of Alphabet. Microsoft is arguably the purest cloud company of the three. 

For SKYY, the three tech giants hold weightings of between 3% to 4% in the fund; for CLOU, the weightings are 1.75% to 2.5%; and WCLD doesn’t hold them at all. 

The cloud giant’s small weightings in these funds are by design. SKYY tracks an equal-weighted index, while CLOU caps the size of any of the “public cloud companies” to 2%. Meanwhile, WCLD focuses on cloud software companies, which is why the cloud infrastructure-focused AWS, Azure and GCP are excluded. 

Cloud Giants Limited  

It makes sense that these cloud ETFs limit the size of the public cloud giants. If they included them and were market-cap-weighted funds, those stocks would dominate the ETFs, leaving other cloud companies with only tiny weightings.  

The aggregate market capitalization of the 75 stocks in the BVP Nasdaq Emerging Cloud Index, which is the index that WCLD tracks, is $1.4 billion. That’s less than the market cap of Microsoft, Alphabet or Amazon alone. 

So instead of focusing on the cloud infrastructure giants, WCLD, SKYY and CLOU are much more focused on smaller cloud companies; particularly, software-as-a-service (SaaS) stocks. 

This includes companies like cybersecurity firm CrowdStrike Holdings Inc., HR software provider Paycom Software Inc., and videoconferencing software provider Zoom Video Communications Inc. Most of those companies are still going strong, but they’ve gotten caught up in the steep retrenchment in high valuation stocks over the past year. SaaS companies—many of which are unprofitable—were some of the most richly valued stocks in 2021. This year, with investors putting a greater emphasis on profits and valuation, they’ve fallen out of favor.  

Some of them have also seen high levels of volatility in their businesses, with the COVID-related work-from-home phenomenon turbocharging demand and then the reopening of the economy leading to a hangover. DocuSign Inc. and Zoom encapsulate that phenomenon.  

SaaS Earnings Season Gearing Up  

Over the next several weeks, many of these SaaS companies will report earnings. and investors will be eager to see whether or not their results match the strength of the public cloud giants. 

Early indications are that growth at the smaller cloud companies is still strong, though perhaps not as durable as that of the giants. 

On Thursday, DataDog, which provides software for monitoring the performance of applications and infrastructure, reported stellar Q2 growth that exceeded expectations, but guided to growth in the second half that was a bit underwhelming. Last week, IT software provider ServiceNow lowered its revenue guidance for the year while citing “elongated sales cycles.” 

For companies like DataDog that still have rich valuations, execution needs to be near-perfect to meet the market’s high expectations. Investors might be a little more forgiving when it comes to more-beaten-down SaaS companies like DocuSign, where growth expectations are lower. 

Follow Sumit Roy on Twitter @sumitroy2