Networking ETFs Surge Ahead

NEW YORK (TheStreet) -- Networking stocks and the two networking ETFs have enjoyed a nice run recently as they have outperformed the rest of the technology sector.

The two networking ETFs are PowerShares Dynamic Networking(PXQ) and iShares S&P North American Networking(IGN).

PXQ is the smaller and less traded of the two, with volume low enough to be considered mildly illiquid. That said, its 19,000 share-per-day average volume has been trending higher as investor interest in the sector picks up. PXQ is the better of two in terms of short- and long-term outperformance.

PXQ tracks the Dynamic Networking Intellidex Index, a passive index that uses screening criteria based on growth, valuation, timeliness and risk to determine which stocks to hold. Four of PXQ's top 10 holdings were not even in this ETF in the fourth quarter of 2007 as allocations shift over time to match the underlying index.

IGN uses a modified market capitalization index that caps a stock at 8.5% of the index. While the underlying index is more stable, the fund's definition of networking is much broader than PXQ's. The top holding is Research in Motion(RIMM), Qualcomm(QCOM) ranks fifth and Motorola(MOT) ranks seventh.

The difference in allocation is why PXQ's return has been doubled that of IGN this year. Big winners include Oclaro(OCLR), up nearly 50%. The optical component maker accounts for 2.8% of PXQ, but is not present in IGN.

Another winner is PXQ top holding VMWare(VMW), up more than 25% in 2010. It is not held by IGN.

One winner in both portfolios has been JDS Uniphase(JDSU) (JDSU), up 40%. The firm accounts for 2.8% of PXQ and 4.3% of IGN.

Over the same period, Qualcomm and Motorola have declined by more than 10%. At nearly a combined 11% of assets, the large underperformance of these two stocks relative to the networking sector has cost IGN dearly.

Since inception, the story has been often the same. PXQ has beaten IGN in four out of the five years both have traded. The three-year annualized return for IGN is -3.9%, while PXQ returned 4.4%. This suggests that PXQ's indexing strategy is more effective, even in 2008, when the fund lost 38% to IGN's 50%.