So You Want to Be in Telecom

This column was originally published on RealMoney on Sept. 7 at 10:22 a.m. EST. It's being republished as a bonus for readers.

The Internet bubble gets all the attention, but the telecom blowup was just as painful and has left investors in the sector wary of re-entry. However, in order to maintain a diversified portfolio, there should be some exposure to the telecom sector.

These days, telecom has about a 3% weight in the S&P 500. Over the last few years, the sector has lagged the broader market badly and its weight in the SPX is much lower than in the past. Often when a sector's weight deviates from the historical norm, it eventually will revert back to it. This, along with how much the sector is disliked, may give telecom shares a chance to outperform.

There are three telecom-sector ETFs: two domestic -- iShares Dow Jones U.S. Telecom Fund ( IYZ) and the Vanguard Telecom Services VIPERs ( VOX) -- and one global, the iShares S&P Global Telecom Sector Index Fund ( IXP).

For domestic telecom exposure, VOX looks to be the best choice. Its portfolio is the most diversified, with 64% of the fund in its top 10 holdings, compared with almost 80% for IYZ. One of the primary benefits of ETFs is that they avoid risks related to the performance of individual stocks. An ETF with too much concentration in the top 10 holdings can lead to more volatility.

Another factor in VOX's favor is its high dividend yield of 2.37%, compared with 1.30% for IYZ and 1.8% for the S&P 500.

Lastly, VOX is cheaper. Its fees amount to only 25 basis points, while IYZ charges 60 basis points. Fees are not necessarily the be-all and end-all in choosing an ETF, but they matter, and because VOX looks like it wins on other fronts, the cheaper fees are a nice extra.

Balance In Everything

Where VOX comes up short is that it has no foreign exposure. I maintain about a 30% weighting in foreign stocks for most clients because I am a big believer in the benefits of foreign diversification as a general principle. I also believe we may be facing a period of below-average returns for U.S. markets over the next few years.

There is value in blending VOX with IXP, a global sector ETF, to gain foreign exposure. The fund is 54% committed to the U.S. and the U.K., and then is spread out between Spain, Japan, France, Germany, Italy, Canada and Australia.

IXP has 66% of its funds invested in foreign telecom stocks and also has a degree of emerging-market exposure -- 6.5% or 7%, depending on whether you believe Greece belongs in that category. Despite the modest allocation to emerging markets, IXP has almost no correlation to emerging-market funds.

The IXP Alternative
This global ETF pairs well with VOX
Source: Your Source Financial

As an example of how to implement a VOX/IXP combo, let's say an investor wants to allocate $30,000 to the telecom sector for a diversified portfolio. This investor also wants to have a 25% weighting in foreign stocks. He could sink $19,000 into VOX and $11,000 into IXP. Because 33% of IXP's holdings are in domestic stocks, this combo creates the 75%-25% blend in the sector that the investor is seeking.

One thing about some foreign countries, and investing in them, is they have fewer moving parts than American firms. Owning the phone company can sometimes be a good proxy for an entire country. This can make the telecom sector particularly appealing for foreign investing.

Both strategies have a downside or two. VOX has 20% in Verizon ( VZ), 14% in SBC ( SBC) and 6.5% in BellSouth ( BLS). IXP weights the three at 8.75%, 7.5% and 4.7%, respectively. All three have been high-yielding laggards. Despite this lag, both VOX and IXP have done reasonably well. At some point, these three Bells will probably provide leadership in the sector, and perhaps the market. If and when that happens, both VOX and IXP could take a serious move up.

A Closed-End Around Emerging Markets

Telecom shares also can offer easy entry into emerging markets. Most exotic investment destinations have easily accessible stocks like Hungary's Magyar Telekom ( MTA) and Compania de Telecommunicaciones de Chile S.A. ( CTC). While owning a single stock, like the Hungarian Bell, may not fit your risk profile, there is a closed-end fund that might: the Emerging Markets Telecommunications Fund ( ETF).

Closed-End Alternative
ETF provides investors with emerging-market exposure
Source: Your Source Financial

ETF trades at a 14% discount to its net asset value and is made up of different types of communications companies from just about every emerging market you can think of. ETF has a close correlation to the emerging-market asset class as measured by iShares MSCI Emerging Markets Index ( EEM).

It is important to note that ETF has high fees, almost 2%. (In the fund's defense, trading Egyptian stocks locally isn't likely to be cheap.)

In many emerging markets, the phone company is one of the largest components, making it a good proxy for that market. This helps explain the tight correlation between ETF and the EEM.

For our investor above who decided that ETF is a good way to access emerging markets, it would be possible to take the same $30,000 and allocate it thusly:

VOX $19,000
IXP $9,000
ETF $2,000

This again creates the 75% domestic, 25% foreign weighting, with a relatively low-risk exposure to emerging markets.

Remember, this is one way to access a lagging sector for a diversified portfolio. We can't know when telecom might lead the market again, but it makes sense to believe it will at some point.

P.S. from Editor-in-Chief, Dave Morrow:
It's always been my opinion that it pays to have more -- not fewer -- expert market views and analyses when you're making investing or trading decisions. That's why I recommend you take advantage of our free trial offer to RealMoney premium Web site, where you'll get in-depth commentary and money-making strategies from over 50 Wall Street pros, including Jim Cramer. Take my advice -- try it now.

At the time of publication, Nusbaum was long Verizon in client accounts, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an e-mail.

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