For a long time, many investors have used ETFs tracking the Nasdaq 100 Index to gain exposure to the world’s technology and internet giants. However, as the ETF market expands, investors are provided with more choices to target specific sectors and investment themes. As such, it is becoming increasingly important for investors to understand the companies in the underlying index to which they are getting exposure – and the tech sector is no different!
Indeed, in the case of technology, sometimes the companies that investors may want exposure to, as part of a specific industry trend, may not actually be technically classified in that industry at all. This means that an ETF with narrow exposure may not actually provide the company exposure being sought by the investor.
How a company is classified
Assignments of industry sectors are generally made under standard classification rules. Perhaps the most common is the Global Industry Classification Standard (GICS), which is a standardised classification system for equities developed and managed jointly by MSCI and S&P. Morningstar also has a Global Equity Classification Structure which, though similar, has subtle differences.
Today, internet companies with a presence across multiple sectors, and whose performance will almost certainly be correlated with the performance of the tech sector more generally, can often be excluded from Tech indices because they have been assigned a different industry classification.
Below is an example of 3 of the biggest ‘tech’ names that you might have thought were Tech stocks but aren’t…and may not be included in some Tech specific ETFs (but are included in the broader NASDAQ-100 Index, and therefore BetaShares NASDAQ 100 ETF, ASX: NDQ).
Amazon – An increasingly common acronym for the quartet of internet powerhouses over recent years is FANG* – which stands for Facebook, Amazon, Netflix, and Google. While it is arguably the most significant of the members of FANG group, it could come as a surprise that Amazon is not considered by any of the major industry classification standards as a technology company. This is because its core business has always been as a discretionary retailer and so it is allocated to the Consumer sector.
The point is, however, that for an investor wanting to get exposure to disruption of retailing, there is arguably no better company than Amazon. Amazon reportedly accounted for 43% of all U.S. online retail sales. But retailing is no longer Amazon’s sole operation. Their cloud computing service, Amazon Web Services, is currently the dominant player in the cloud services market, and now accounts for 11% of total group revenue, with latest revenue figures up 42% year on year. This actually accounted for a larger proportion of operating income than its retail operations for H1 2017.
Netflix – The N in FANG and the web-based global disrupter of traditional television media. Netflix, like Amazon, is classified across the board as a Consumer business. Subscriber growth for Netflix continues to grow at an impressive rate in the face of forecasts of a slowdown. The company recently reported it had added 10.2 million new subscribers in H1 2017, which was a 21% spike over the prior corresponding period, with its international segment growing 170% year on year! Profitability has also been growing – with revenue from its core U.S. business climbing to 37% of overall revenue, as it continues to benefit from price rises and the shift to HD offerings.
PayPal – The brainchild of Elon Musk, Paypal has revolutionised the way people transact securely over the internet, without having to disclose their credit card details directly to the retailer. The company is now the world’s largest digital wallet and a leader in mobile and e-commerce payments. PayPal allows its customers to load their digital wallets via both debit/credit cards and to also securely use their transactional bank account. The recently launched PayPal Go has allowed it to build a physical presence in smaller stores. Significantly, the company has deals with both Apple and Samsung to be part of their digital wallets.
PayPal is widely seen as a play on the secular shift towards a cashless society and the penetration of e-commerce into our daily transactions. In its latest quarterly earnings result, PayPal reported the number of payment transactions up 22% year on year, with total payment volumes exceeding $100 billion for the first time. It also reported revenue up 18%. But, once again, some tech indices would exclude this company. For example, Morningstar classifies PayPal within the Financial Services industry.
With the explosive growth of e-commerce and the increasing digitalisation of our daily lives, it’s easy to see how many of these sector decisions may now seem counterintuitive…Is a company that sells consumer goods still in the consumer discretionary sector if its transactions are made exclusively online? Is a digital financial services company which is built on a unique IT infrastructure, not a technology exposure?
As companies continue to move online and expand into business lines outside their original industries, this could become an increasing issue for some indices tracking these kinds of sectors and investors seeking specific exposure via ETFs, on the belief they provide exposure to certain companies. The most important takeaway is that, as with any investment, investors should ensure they look under the hood at the individual holdings in the underlying index, to see whether they are getting the exposure they actually want.
* The acronym FANG, not FAANG, has been used intentionally throughout this post. FANG was originally coined as an acronym for the new world web-based market leaders. Regardless of its ongoing growth, Apple (often referenced in relation to FAANG stocks) is neither web-based nor new world. It’s a consumer goods manufacturer that’s been around since the 1970’s.