Top ETFs In Neglected Telecom Sector

Telecom stocks are doing well this year. The sector is neck-and-neck with utilities for title of "best-performing sector of 2016" as investors gravitate toward areas of the market considered safe and with high yields.

Yet despite the solid performance, telecom hasn't generated the interest one might expect. Perhaps that's because of its size. In the U.S., out of the 10 current sectors under the Global Industry Classification Standard, it's the smallest. Its 2.7% weighting in the S&P 500 falls below that of utilities at 3.2% and materials at 2.9%.

Telecom is also the sector with the fewest number of firms. Only five make the cut for the S&P 500, and there are only 38 U.S. telecom stocks in total across the whole market―most of them small-caps.

Perhaps most interestingly, from a market-cap perspective, two firms absolutely dominate the telecom sector: AT&T and Verizon. Combined, the duo make up 85% (46% for AT&T; 39% for Verizon) of the market capitalization of the telecommunications sector.

Getting Around Concentration Constraints

That's posed a bit of a conundrum for exchange-traded funds. IRS rules dictate that a single firm cannot make up more than 25% of a regulated investment company (RIC)-compliant fund―a category that includes ETFs and mutual funds.

According to MSCI, "two key requirements at the end of each quarter of a tax year for RIC-compliant funds are 1) no more than 25% of the value of the fund’s assets may be invested in a single issuer, and 2) the sum of the weights of all issuers representing more than 5% of the fund should not exceed 50% of the fund’s total assets."

Some ETF issuers have dealt with these constraints by rolling telecom stocks into other sector ETFs. The Technology Select Sector SPDR Fund (XLK) and the Guggenheim S&P 500 Equal Weight Utilities ETF (RYU) are examples of these, where the telecom sector is combined with technology and utilities, respectively.

Another way issuers have gotten around these restrictions is with capped indexes. For instance, MSCI's 25/50 indexes cap the weight of individual stocks below RIC-compliant maximum levels. The MSCI US IMI Telecom Services 25/50 Index is tracked by the Vanguard Telecommunication Services ETF (VOX), a pure play ETF on the telecom sector.

VOX is the largest telecom-focused ETF, with $1.5 billion in assets, and it has returned 14.7% so far this year. Compared with the unrestricted benchmark, the fund has a lesser-weighting in AT&T and Verizon—22.5% each.

Even so, VOX has a hefty 12-month distribution yield of 4.3%, something that telecom investors expect from the sector.

YTD Returns For VOX, IYZ, FCOM, XTL

Other ETF Options

Aside from VOX, there are a few other U.S. telecom ETFs that have gathered a respectable amount of assets under management. The iShares U.S. Telecommunications ETF (IYZ), with $600 million in AUM, is one of them, and is up 13.1% year-to-date.

IYZ tracks the Dow Jones U.S. Select Telecommunications Index. Like the aforementioned MSCI index, it caps the weights of the two giants in the space, but it adds an additional constraint: "The aggregate weight of the five largest companies in the index is capped at 65%."

The result is a significantly reduced weighting in AT&T and Verizon―about 10% each―and higher weightings in companies like Sprint and T-Mobile.

IYZ currently has a distribution yield of 1.6%.

The $160 million Fidelity MSCI Telecommunication Services ETF (FCOM) is another fund in the space. Its 0.08% expense ratio is the lowest in the segment, beating out IYZ's 0.44% and even VOX's 0.10%.

FCOM tracks a similar index as VOX, the MSCI USA IMI Telecommunication Services 25/50. Year-to-date, the ETF is up 14.3% and currently has a distribution yield of 2.2%.

Finally, the SPDR S&P Telecom ETF (XTL), with $29 million in assets, completely skirts the issue of concentration by equal-weighting its portfolio. Currently, no individual stock within the fund has more than a 4% weighting.

Even with its dramatically different weighting scheme, XTL's total return of 13.7% this year is in line with the other telecom ETFs (though it's underperformed over the last five years, as can be seen from the chart below). The fund has a 12-month yield of 1.2% and an expense ratio of 0.35%.

5-Year Returns For VOX, IYZ, XTL

Contact Sumit Roy at [email protected].