The Hottest Technology Funds

NEW YORK ( TheStreet ) -- When they want exposure to technology, many investors turn to Technology Select Sector SPDR ( XLK), which tracks the technology stocks of the S&P 500. But some less-well-known choices have outperformed the SPDR fund lately.

While Technology Select Sector returned 9.8% this year, Guggenheim S&P 500 Equal Weight Technology ( RYT) gained 20.1%, according to Morningstar. Other exchange-traded funds that outperformed by a wide margin include PowerShares S&P Smallcap Information Technology ( PSCT) and First Trust Nasdaq Technology Dividend ( TDIV). The winners have excelled because they give little or no weight to some of the biggest mega-cap stocks, which have been laggards.

Much of the SDPR fund's shortfall lately has been due to a handful of stocks. Apple ( AAPL), which accounts for 13.7% of the assets in the ETF, has lost 19.9% this year. Other big SPDR holdings that have delivered modest returns are International Business Machines ( IBM) and AT&T ( T).

When the mega-caps rebound, the SPDR fund will outdo its competitors. Still, the smaller ETFs are worth considering because they can help to diversify portfolios -- and it is possible that the funds will outdo the SPDR fund over the long term.

A top choice is the Guggenheim equal-weight fund. During the past five years, the equal-weight fund returned 9.3% annually, compared to 8.7% for the SPDR sector fund. The two funds hold basically the same stocks, but the allocations are very different.

Like the S&P 500 and most other common benchmarks, the SDPR fund weights its holdings according to their market capitalizations. So the stocks with the greatest market values account for the most weight. The equal-weight fund puts about the same assets into each of the 70 stocks in the technology sector.

The market cap approach tends to put heavy weightings in a few stocks. The SPDR fund has 8.6% of assets in Microsoft ( MSFT), compared to weighting of 1.7% for the equal-weight fund. Because of SPDR's emphasis on mega caps, the holdings in the fund have an average market capitalization of $100 billion, compared to $16 billion for the Guggenheim equal-weight fund. A focus on the biggest stocks could be a disadvantage for buy-and-hold investors. Many academic studies have shown that smaller stocks outdo bigger ones over the long term.

Proponents of the equal-weight approach argue that the system can outperform because it requires regular rebalancing. Under the system, stocks that soar must be trimmed back to their target weightings. Meanwhile, the fund has to buy more shares of laggards that sink below their target. In effect, the portfolio manager is constantly buying cheap stocks and selling expensive ones, a formula for outperformance. In contrast, funds that rely on market-cap weighting must continually buy more of the hottest stocks.

While the rebalancing may provide a boost over the long-term, the system does not shine every year. The equal-weight fund has lagged SPDR during difficult markets when investors preferred the safety of mega-caps. In the turmoil of 2008, SPDR outpaced the equal-weight fund by four percentage points.

PowerShares S&P SmallCap Information Technology does not hold Apple or any of the other big stocks in the S&P 500. Instead, the ETF owns the technology names from the small-cap S&P 600 index. Many of the little-known names in the small-cap benchmark have been soaring lately. In the past year, the fund returned 33.2%, outpacing the SPDR fund by 20 percentage points.

The small-cap fund has benefited from the improving economy. As investors have become more confident, they have gravitated to smaller technology stocks. The small stocks have seemed particularly appealing because they derive most of their sales in the U.S. In contrast, many mega caps are big exporters. That has been a negative factor at a time when the European economy remains stalled, and investors have begun to worry about the outlook for China and other emerging markets.

First Trust Nasdaq Technology Dividend has an average market capitalization of $55 billion. While the portfolio includes mega-cap dividend payers such as Apple, the fund does not own Google ( GOOG), which does not pay a dividend. The dividend fund yields 2.8%, compared to a figure of 1.9% for the SPDR fund.

The First Trust fund could be particularly appealing for income-oriented investors who have emphasized traditional dividend funds such as iShares Dow Jones Select Dividend ( DVY). The traditional choices have focused on sectors such as utilities and consumer staples, which have long paid rich dividends. But the dividend funds are typically underweight technology, since many names in the sector have not paid dividends.

By adding the First Trust fund to a dividend portfolio, investors can diversify their holdings. In addition, many technology companies are rapidly increasing their dividends. Such dividend growth could boost the stocks and reward patient investors with growing income.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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