IGV: Software Industry Offers Appealing Risk-Adjusted Performance


In a previous article, our Efficient Frontier had revealed that a portfolio efficiently combining the Utilities and Tech sectors allows investors to achieve the best risk-adjusted performance amid the ongoing trade war. Our results had suggested a majority allocation to Utilities, and a smaller allocation to Tech, given that the defensive attributes of the former allows one to minimize portfolio risk, and the latter to boost portfolio returns. In this article, we further assess the risk-adjusted performances of the two sectors, and evaluate how the Software industry (within the Tech sector) offers even better risk-adjusted performance than both the overall Tech sector and the defensive Utilities sector.

Prospectus Review

The iShares Expanded Tech-Software Sector ETF (IGV) is the most popular investment vehicle tracking the Software industry. Prior to evaluating the risk-adjusted performance of the IGV ETF, we must assess the fund. The IGV ETF seeks to track the performance of the ‘S&P North American Expanded Technology Software Index’. Out of all ETFs that offer exposure to the Software industry, this fund has the highest Assets Under Management ($2.69 million) and average daily trading volume (546,020), according to data from ETFdb. A higher trading volume offers better liquidity for investors (ease of buying and selling).

Keep in mind that this fund does not invest in all Software stocks within its underlying benchmark, but instead uses a “Representative Sampling” strategy, whereby it invests in a sufficiently large sample of stocks that are best representative of the overall benchmark performance, in terms of factors such as “industry weightings”. As a result, the fund may not be able to perfectly replicate the performance of the underlying benchmark, which results in tracking errors. Historical discrepancies between the fund and benchmark performances can be found below.

Source: iShares

Hence, investors that are looking to gain exposure to the Software industry through this ETF should be mindful of these tracking errors.

The two main other fund choices that seek to offer exposure to the Software industry are the Invesco Dynamic Software Portfolio ETF (PSJ) and the SPDR Software & Services ETF (XSW). In comparison to IGV, these ETFs offer higher weightings to small-cap and medium-cap stocks instead of large-caps. IGV offers 71% exposure to large-cap stocks, whereas PSJ and XSW offer 41% and 0% exposure, respectively, to large caps. While smaller-caps are believed to offer more growth potential than large-caps, one should also consider the fact that small-caps tend to witness higher volatility, especially during periods of equity market and economic uncertainty, hence making IGV more appealing.

Risk-adjusted performance analysis

Sharpe ratio and Sortino ratio are two of the most common risk-adjusted performance measures. However, the Sharpe ratio incorporates the standard deviation; considering downside volatility as well as upside volatility as risk to investors, which is certainly not the case. Conversely, the Sortino ratio allows for more realistic risk-adjusted performance analysis, as it only considers downside deviation as risk. The following sector ETF will be used as proxies for the Tech sector, Utilities sector and Software industry: the Technology Select Sector SPDR ETF (XLK), the Utilities Select Sector SPDR ETF (XLU), and iShares Expanded Tech-Software Sector ETF, respectively.

The monthly returns for the S&P 500 and each ETF have been calculated since January 2018 (beginning of trade war), based off of which the Sortino ratios have been determined. Given that we are using monthly returns, the 1-month Treasury bill yield will be used as the risk-free rate for calculating the excess returns. For optimum accuracy, no average risk-free rate has been used for all months, but instead the actual 1-month yield for each specific individual month has been used to determine each monthly excess return.

Furthermore, usually for Sortino ratio calculations the standard deviation in the denominator determines the deviation of each negative return from the average negative return. However, instead, we will be determining the deviations away from ‘0’, to better examine their deviations into negative territory. Because logically, we are not concerned about returns deviating away from the average negative return, but are actually concerned about how much our returns fall into negative territory away from 0. Hence, our Modified Sortino ratio allows for better risk-adjusted performance analysis. The results can be found in the table below.

Note: the Sortino ratios have been annualized through multiplying them by √12.

Usually, negative Sortino ratios are ignored by analysts; dismissed as meaningless. However, incorporating these negative results into comparative analysis can help reveal useful insights. For positive Sortino ratios, the higher the better, as it implies higher excess returns relative to downside risks. For negative returns, the smaller (and closer to 0) the better, as we would want a minimal loss. However, a smaller negative Sortino ratio could be the result of two factors: a small loss in the numerator (which is ideal), or a large downside standard deviation in the denominator (which is not ideal). Therefore, simply looking at the negative Sortino ratios at face value is not enough, as we must also take into consideration the size of the losses and standard deviations. At face value, out of the negative Sortino ratios in the table above, Utilities offers the worst risk-adjusted performance, with a Sortino ratio of -1.20, while the S&P 500 and XLK offer better results, at -0.67 and -0.38, respectively. However, XLU also poses the lowest downside standard deviation (2.93) in the denominator, therefore inflating the magnitude of its negative Sortino ratio, whereas S&P 500 and XLK hold much higher standard deviations, 7.04 and 5.70 respectively, misleadingly resulting in smaller negative Sortino ratios.

Nevertheless, even though the Software industry poses the highest downside standard deviation (7.14), it is also the only ETF to offer a positive Sortino ratio. Hence, it offers a better risk-adjusted performance than the S&P 500, Tech sector, and even the defensive Utilities sector. Hence, this makes Software an industry that investors should certainly not ignore amid the ongoing trade tensions and slowing global economic conditions.

Unlike industries like the semiconductors space, the Software industry holds little exposure to China, making it an attractive space to hold exposure to amid greater trade uncertainty. Furthermore, Software companies tend to work with a recurring revenue business model, allowing for stable sales revenue. Amid slowing economic growth, business efficiency becomes ever more important to support bottom line earnings, which encourages businesses to continue spending on Software services to stay competitive. Moreover, within Software industry, the Cloud industry is witnessing strong secular growth trends as more and more corporations adopt the new technology to stay ahead within their respective industries, which is also boosting the Software industry’s growth rate. As a result, Software companies tend to perform better than other areas within Tech even amid slowing economic growth. In fact, for Q2 2019, out of all the Tech industries, the Software industry is expected to deliver the highest revenue growth rate (8%) and earnings growth rate (5%). Hence, this makes it an attractive industry to hold exposure to within a portfolio, as it offers both high growth rates as well as a form of defensiveness amid trade uncertainty/ slowing economic growth.

Top holdings

Let us assess some of the fund’s top holdings and their performance/growth prospects going forward.

The largest holding of the IGV ETF is Adobe (ADBE), with a weighting of 8.89% (at time of writing). This company is benefiting from secular growth trends in three distinct Cloud business segments: Document Cloud, Creative Cloud, and Experience Cloud. Adobe is able to offer superior visually oriented solutions, allowing the company to be a market leader in the Creative Cloud and Experience Cloud space. Specifically regarding Experience Cloud, advancements in consumer experience give a big importance to visual aspects, giving Adobe an edge in this space. In terms of the Document Cloud space, Adobe is a leader in offering PDF solutions, and given that the digitalization of documents is on the rise (such as the utilization of online signatures), Adobe is at the forefront to capitalize on this growing Cloud space. Therefore, given Adobe’s market-leading statuses in its three Cloud segments witnessing secular growth, the stock certainly has attractive growth potential going forward, consequently leading the IGV ETF higher as well.

The fund’s second largest holding is Oracle (ORCL), with a weighing of 8.79% (at time of writing). This is also a company that offers Cloud services, more specifically offering Autonomous Cloud Database and the Cloud ERP SaaS Service. However, the company’s Cloud segment has actually been struggling, failing to compete effectively against competitors, including Amazon (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT) and even VMware (NYSE:VMW). In fact, in its latest earnings report, the company delivered yoy revenue growth of 1%, while Adobe delivered 25% growth over the same period. Oracle has been taking steps to deal with its ailing Cloud segment, such as by recently partnering with Microsoft to allow its customers to run Oracle Software on both Oracle Cloud and Microsoft Azure, in order to avoid losing its Software customers to competitors. Nevertheless, the stock has been weighing down the IGV ETF, and actually presents a risk to investors if Oracle does not successfully adjust its strategies going forward. I believe the fund’s allocation to Oracle is a drawback to IGV investors.

The fund’s third largest holding is Microsoft, with a weighting of 8.32% (at time of writing). This is the largest company in IGV’s portfolio, as the company has a market cap of over $1 trillion. Microsoft is actually one of the best-performing stocks in the overall equity market, and is what enhances IGV’s defensive characteristics amid heightened market uncertainty. Microsoft Azure is the second-largest player within the Cloud industry (only behind Amazon’s AWS), and is the fastest-growing unit at the company, witnessing 73% revenue growth in its latest quarterly earnings report (much higher than the company’s overall revenue growth rate of 14%). While there have been concerns over the recent slowdown in Cloud revenue growth (was growing at a rate over 100% two years ago), Azure is still growing faster than AWS was when it was Azure’s size. Microsoft is well positioned to deliver on corporations’ data storage and analytics needs and benefit from the secular growth trends in the three Cloud services segments: Infrastructure as a Service (IaaS), Platform as a Service (PaaS), and Software as a Service (SaaS). Apart from Cloud, the company also offers other sources of growth, such as its professional networking platform ‘LinkedIn’, which delivered 27% revenue growth in its latest quarterly earnings report. Hence, this is a profitable, high-growth company that is likely to continue boosting the IGV ETF higher going forward.

While the ETF has some laggards such as Oracle, overall the fund holds various high-growth Software companies, including Salesforce.com (NYSE:CRM), Intuit (NASDAQ:INTU) and ServiceNow (NYSE:NOW), which offer appealing growth potential for the IGV fund.


While the Software industry overall does offer compelling growth potential, we must also take into consideration potential risks.

While Cloud Software is offering appealing secular growth prospects for the industry, any slowdown in growth, especially for IGV’s largest holdings, could dampen stock price performance, as the markets adjust the price to reflect slower future growth. For instance, Microsoft Azure’s revenue growth has slowed from 116% (two years ago) to 73% (in latest quarterly earnings report). However, the stock has continued to climb higher regardless of such a slowdown. Even if Cloud services revenue growth slows, it is still an industry that offers immense growth potential that is not easily found in any other area of the equity market, bolstering the appeal of the IGV ETF.

The stretched valuations of the industry also potentially make them sensitive/vulnerable to pullbacks. In the table below, the valuation metrics of IGV are compared to the Tech sector and the S&P 500.

Data Source: Morningstar

Evidently, the IGV ETF is more expensive by almost every metric, though it is cheaper in terms of Price to Book. While the expensive valuation repels certain investors, keep in mind that because the Software industry offers unique growth potential, investors seeking high-growth will have few alternative options, and thus will be willing to pay more for excess growth opportunities. This is especially true during an economic slowdown (the likes of which we are currently witnessing), when such sustainable growth is even harder to find. Therefore, while IGV may be expensive and may occasionally witness pullbacks on valuation concerns, it is unlikely to witness a deep slump to the point where it reaches extremely cheap valuations. Therefore, market participants investing in such growth securities should acknowledge that valuation risk is common when it comes to growth investing.

Bottom Line

While the Tech industry overall is considered risky to hold exposure to amid the ongoing trade tensions and slowing economic growth, the Software industry actually provides higher returns and better shelter from the US-China trade war.

Most companies within the IGV portfolio offer attractive growth potential, specifically benefiting from secular growth trends in the Cloud space. While valuations are certainly expensive relative to the overall market, the industry also offers excess growth potential that cannot be easily found elsewhere, hence justifying its higher valuations, especially amid slowing economic conditions when growth opportunities are scarcer.

Evaluating the risk-adjusted performances since the beginning of the trade war (January 2018) revealed that IGV was the only ETF to deliver a positive Sortino ratio, even higher than the Utilities sector. Hence, investors seeking attractive returns while avoiding China trade exposure should not only rely on the defensive Utilities sector, but should also consider incorporating the Software industry specifically (out of the overall Tech sector) to boost portfolio returns.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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