Litmus Test for New ETFs — Should You Jump Into this Smart Phone Fund?

Jared Levy, Editor, Smart Investing Daily
Tuesday, 22 February 2011

technology cellphone I was out to dinner at a swanky restaurant here in Dallas where you would think etiquette would prevent the use of electronic devices at the table. I was blown away when I looked around the room and saw that about 40% of the patrons were using their smart phones to exchange pictures, surf the web, check out the reviews of some of the wines on the menu, etc. These aren’t kids without manners; the smart phone is transcending generations as the bulk of the diners using the devices were over 50!

Smart phones at dinner

For years now, I have been preaching about the huge upside growth potential in the smart phone sector and have outlined several stocks such as Google (GOOG:NASDAQ), Apple (AAPL:NASDAQ), Research in Motion (RIMM:NASDAQ) and others to invest in. I still believe that the smart phone will become the proverbial “wallet” you carry around with you, keeping you in touch wherever you are and perhaps one day even replacing your identification and credit cards.

But is investing in a company like Apple, Google, Research in Motion and Qualcomm (QCOM:NASDAQ), which are some of the leaders in the smart phone market, the best way to profit from this mobile fun technology trend? The theory is that by investing in the biggest, strongest and most well-positioned companies, you can increase your chances of success in a trade. But it’s not that easy.

Times Change and So Does the Technology Industry

What if a market leader like Apple were to become a market laggard down the road? You’re probably thinking that there is no way a company like Apple could be a laggard at anything. This type of thinking can hurt you: Nothing is forever in the stock market, especially in the technology industry.

Six years ago, if you were to ask me what companies were set to control the smart phone device space, I probably would have said RIMM, Palm (remember the Palm Pilot and Treo?) and maybe Nokia (NOK:NYSE) — Google and Apple weren’t even in the game; there was no Android or iPhone.

Back then, Nokia was quite simply the mobile phone giant, with the capital and brand to create something great. It now faces a daunting, pivotal point in its history, as I outlined a couple of weeks ago in Smart Investing Daily.

In a relatively short period of time, the mobile phone industry saw a dramatic shift in power and popularity in the industry, due to changes in consumer habits, related industry trends, technology shifts and corporate strategy. Kings of the technology industry became peasants and vice versa — it will happen again.

**If you bought Nokia back in January 2004, you could have realized profits, but if you simply held it, your P&L might not look that pretty.

Can This Smart Phone ETF Help?

If I have scared you into thinking you have to watch the companies you invest in like a hawk, then I have done my job. Never close your eyes on the market. But there might be a way to take advantage of this sector and leave the heavy lifting to someone else; the question is whether it makes sense for you.

A new ETF has just hit the market. It may provide you with a good investment vehicle for the smart phone sector, but let’s take a closer look to see if it’s a good bet. Created by First Trust, the NASDAQ CEA Smart Phone Index (FONE:NASDAQ) allows you to buy multiple smart phone companies (over 70) using one ETF. The ETF charges 0.70% in expenses and is not currently optionable, which may change in time. Let’s look at the fund as a whole… This is your basic litmus test, and in general it can apply to all ETFs you’re thinking of investing in.

Smart Phone Company Diversity

This characteristic can be a double-edged sword. On one hand, buying 73 different smart phone companies will help prevent major losses if one or a handful of the companies struggle, but it may also prevent you from achieving great returns. I like the fact that they have spread out risk in this ETF, but I think it may be too thin. In other words, diversity in this case may be too much of a good thing. I have to mention that the fund is NOT actively managed and is simply based off of an index created by the Nasdaq OMX, which means that if trends in the industry change, this ETF will not react and modify its holdings as quickly.

(Investing doesn’t have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Sara Nunnally simplify the stock market for you with our easy-to-understand investment articles.)

Allocation

Of the 73 companies held in the ETF, many of them are well diversified themselves and not really focused in the smart phone sector. Although their exposure to the mobile industry may change with time, that is not guaranteed. I would have liked to see companies like Apple, Google, Research in Motion, Qualcomm, Skyworks (SKWS:NASDAQ) and HTC (2498:Taiwan) more heavily weighted. I do like that the service providers such as AT&T, Verizon and Sprint are lower on the weighting scale. Another thing to note: 45% of the index weight is allocated to handsets, 45% of the index weight is allocated to software applications and hardware components, and 10% of the index weight is allocated to network providers.

Undiscovered Technology Gems

To be fair, there are several companies contained within the fund that I am not too familiar with. Over time, I will research them and give you my thoughts on their future prospects. As the space grows, mergers and acquisitions of some of the smaller, less popular companies could bode well for the fund and perhaps provide a boost to its value.

Should You Buy This Smart Phone ETF?

At first glance, this ETF can offer investors who want smart phone exposure without doing too much homework a place to invest. It also gives you exposure to foreign companies that may not trade here in the States and that may be hard for the average investor to own.

That said, according to our litmus test, FONE may not be right for all investors.

For those of you who work with a financial advisor to do your research (or do it yourself), it might be better to narrow your selection to around 10-20 of these companies, rather than 73. As I said before, the number of smart phone companies in this ETF might limit returns. By choosing a smaller number of companies from this list, you can create your own ETF, so to speak. Talk to your broker about buying a different amount of each of the companies in your own account to create your own asset allocation.

This “Create Your Own ETF” option might be the best of both worlds, mining the best companies from this ETF that work well in your existing investment portfolio.

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