2022 will end up being a year that most investors will want to forget. Not only will the S&P 500 (SPY) and Russell 2000 (IWM) finish the year down somewhere in the neighborhood of 20%, this year has been a complete reversal of the trends that made investors the most money in the post-COVID recession period. Back then, it was all about mega-caps, tech, growth and FAAMG names. This year, the big winners have been dividend stocks, low volatility and value. A lot of investors were positioned in the wrong ways coming into the year and that's likely led to even bigger losses.
The tech sector could finish the year down 30%. It's been a consistent laggard throughout the past year as inflation, interest rates and an economic slowdown all work against it. On top of that, valuations had a lot of unwinding to do, which only exacerbated losses. Drilling down to the sub-sector level, some returns are even worse. Cloud computing (SKYY), internet (FDN), robotics (BOTZ) and blockchain (BLOK) stocks are all on pace for 40%+ losses. If you were overweight tech in 2022, you've experienced a lot of pain.
One sector that's fared at least a little better has been cybersecurity. It's fallen significantly along with the rest of the tech sector, but it has benefited from a steady stream of "demand". The notion of identifying and preventing data breaches and hacks now applies to almost every area of our economy and day-to-day lives. The good news for cybersecurity stocks is that companies and governments are investing billions of dollars to secure their systems, data and infrastructure. It remains one of the undeniable true growth sectors that is almost becoming defensive in nature. Cybersecurity is likely to remain impervious to economic cycles.
The problem today is that the cybersecurity sector is still pretty expensive. The S&P 500 is back down to a P/E ratio of around 17, but cybersecurity still trades at around 26 times earnings. If recession does indeed arrive in around 12 months as many watchers expect, cybersecurity stocks are likely to underperform further on valuation contraction alone. With value dominating the narrative for the time being, cybersecurity stocks may face a tough environment again in 2023.
From a long-term, buy-and-hold perspective, cybersecurity still makes a lot of sense. Its combination of long-term growth potential and growing demand for services, adding an overweight to this sector could be a way of tilting your portfolio towards above average returns.
Ranking The Cybersecurity ETFs
The variety of ETF choices makes distinguishing the best from the rest a little challenging. You've probably heard most financial pundits talk about focusing on funds with low expense ratios. That can certainly be a big factor in deciding which ETF to go with (it's probably the most important factor, in my view), but there are a lot of things that could go into making the right choice.
That's where I'm going to try to make things easier for you. Using a methodology that I've developed, which takes into account many of the factors that should be considered and weighting them according to their perceived level of importance, we can rank the universe of available ETFs in order to help identify the best of the best for your portfolio.
Now, this certainly won't be a perfect ranking. The data, of course, will be objective, but judging what's more important is very subjective. I'm simply going off of my years of experience in the ETF space in helping investors craft smart, cost-efficient portfolios.
Methodology & Factors For Ranking ETFs
Before we dive in, let's establish a few ground rules.
First, all of the data is used is coming from ETF Action. They have gone through the ETF universe to identify and categorize those ETFs used here. There are many that qualify and we'll be using their categorization as a starting point. Many thanks to them for opening up their vast database for my use.
Second, let's run down the factors I used in the ranking methodology.
- Expense Ratio - This is perhaps the most important factor since it's the one thing investors can control. If you choose a fund that charges 0.1% per year over a fund that charges 1%, you're automatically coming out ahead by 0.9% annually. You can't control what a fund returns, but you can control what you pay for the portfolio. Lower expense ratios equal more money in your pocket.
- Spreads - This relates to how cheaply you can buy and sell shares. Generally speaking, the larger the fund, the lower the spreads. Bigger funds usually have many buyers and sellers. Therefore, it's easier to find shares to transact and that makes them cheaper to trade. On the other hand, small funds tend to trade fewer shares and investors often need to pay a premium to buy and sell. Considering expense ratios and spreads together usually give you a better idea of the total cost of ownership.
- Diversification - Generally speaking, the broader a portfolio is, the better chance it has at reducing overall risk. A fund, such as the Energy Select Sector SPDR ETF (XLE), provides a good example. 45% of the fund's total assets go to just two stocks - ExxonMobil and Chevron. By buying XLE, you're putting a lot of faith in just those two companies. An equal-weighted fund, such as the Invesco S&P 500 Equal Weight Energy ETF (RYE), would score higher on diversification than XLE.
- FactSet ETF Scores - FactSet calculates its own proprietary ETF ranking for efficiency, tradeability and fit. They basically are designed to tell us if an ETF is doing what it sets out to do. I'm not going to copy and paste that work that they're doing, but there is some influence there to make sure my rankings are on the right path.
There are a few other minor factors thrown into the mix, but these are the main factors considered.
One thing that is not considered is historical returns. Most ETFs are passively-managed and are simply trying to track an index, not outperform. ETFs shouldn't be penalized for low returns simply because the index they're tracking is out of favor at the moment.
I'm ranking ETFs based on more basic structural factors. Are they cheap to own? Are they liquid? Do they minimize trading costs? Do they maintain risk-reducing diversification benefits?
Being in the bottom half of the list doesn't automatically make a fund "bad". It simply means that due to a low asset base, a high expense ratio, a concentrated portfolio or some other factor, it poses additional costs or downside risks.
Best Cybersecurity ETF Rankings
The universe of cybersecurity ETFs is somewhat limited. Just one ETF accounts for more than half of the sector's assets and almost all assets reside in a total of four ETFs. While the number of options are relatively few, there's enough uniqueness between how these portfolios are constructed that they aren't necessarily interchangeable.
The ETFMG Prime Cyber Security ETF (HACK) was the first to hit the market back in 2014. Amid the initial cybersecurity boom, this fund has more than $1.4 billion in assets in less than a year. Today, it's still the 2nd largest ETF in this space, but comparatively lackluster performance has taken some of the shine off of this portfolio. HACK has a few distinctions. Despite cybersecurity being a true global industry, this fund has nearly 90% of assets in U.S. based companies, the highest number within this group. It also has the lowest percentage of assets in the top 10 holdings and its 59 individual positions is nearly the highest as well. In other words, this is perhaps the most diversified fund on this list. In a lot of cases, that's a good thing, but maybe not for a sector-specific fund. A lot of investors are probably looking for more concentrated exposure when investing in a sector and HACK doesn't necessarily offer that. It's also easily the worst performing fund over the past three years among ETFs that have been around that long.
The First Trust Nasdaq Cybersecurity ETF (CIBR) was the 2nd cybersecurity launched but has since become the torch bearer for the industry. I think this ETF is positioned a little better than HACK. It's got a bit more international exposure and has just 37 individual holdings. That makes CIBR a bit better as a pure play on the sector. It's a little top-heavy, so you're getting a bit more risk exposure from individual names, but overall I prefer CIBR to HACK based on portfolio composition.
Neither one of these ETFs take the top spot in my rankings. That honor belongs to the iShares Cybersecurity & Tech ETF (IHAK). The lower expense ratio was certainly a factor in pushing IHAK to the top and the asset base is just large enough that tradeability is good and spreads are minor. From a standpoint of composition, IHAK was one of the better global allocations (just 75% of assets come from U.S. companies) and has a modest allocation to emerging markets, something that most of the other funds in this category don't have. It also has the heaviest tilt towards mid- and small-caps. From a risk standpoint, this ETF probably falls on the higher end of the spectrum, but the cost and diversification advantages make it an understandable choice for the #1 spot.
If I were to choose a cybersecurity fund for my own portfolio, however, I'd probably go with the Global X Cybersecurity ETF (BUG). It does probably the best job of providing concentrated exposure, limiting the portfolio to just around 25 names, while offering a geographically diverse allocation strategy. It has roughly a 2/3-1/3 split between U.S. companies and foreign developed market companies, including a 14% allocation to Israel, a fast-developing technology hub globally. It also has about 1/3 of assets each in large-, mid- and small-cap names. Its expense ratio, which is 10 basis points lower than both HACK and CIBR, gives it another advantage.
The WisdomTree Cybersecurity ETF (WCBR) is approaching its 2-year anniversary, but has failed to really gain any traction. Its got the lowest expense ratio of the bunch, but its relatively late entry to the game has been an issue in its ability to take market share away from the bigger names.