VGT: This Popular Tech ETF Gets By Without Amazon, Facebook, Or Google, But It Shouldn't Have To (NYSEARCA:VGT) (2024)

QQQ is the Biggest Tech ETF But it May Not Be the Best

If you believe that most of the companies driving the growth of the U.S. stock market will continue to emerge out of the Tech sector, you might be tempted to invest in a Tech ETF. By far, the largest of these is the Invesco QQQ ETF (QQQ) which with $144 billion in assets is by far the largest. It holds 103 stocks, all of them listed by NASDAQ and has an expense ratio of .20%.

But there is another huge tech ETF available to investors that follows a broader index and holds more stocks. It is the Vanguard Information Technology ETF (NYSEARCA:VGT), which has $36.9 billion in assets. It holds 330 stocks from all the major US exchanges, not just NASDAQ. Its expense ratio of .10% is half that of QQQ. Though both ETFs have experienced impressive returns, the most popular is not necessarily the best. According to Morningstar, VGT has outperformed QQQ over the past 5 years by about 25%. The outperformance holds up even when you examine many other time intervals.

VGT Five-Year Total Return Compared to QQQ

Source: Morningstar

VGT Only Recently Started Outperforming the Broader Market Indexes

VGT's success is relatively recent. Between the time it started trading back in 2004 and 2015, VGT never did better than to match the returns of either the S&P 500 or the funds tracking the total stock market, like Vanguard Total Stock Market Index Fund/ETF (VTSAX) and (VTI). And there were long periods when VGT underperformed both. But, in the spring of 2016, it started the dramatic ascent that has led it to consistently achieve almost double the total return of the S&P 500 and the Total Stock Market Index.

In the chart below, you can see how its performance compares to that of the Vanguard 500 Index Fund (VFIAX) and the Vanguard Total Stock Market Fund. (I choose these funds to compare it to because are funds following the broad market indexes that you could have actually invested in. Comparisons to the S&P 500 index, which are often used, ignore the fact that investors would have been paying fund expenses and could not realize the full value of the conceptual index.)

VGT Total Return Since Inception Compared with Vanguard's 500 Index Fund and Total Stock Market Index Fund

Source: Morningstar

Much of this outperformance was driven by the way that a few huge blockbuster tech stocks have dominated VGT. At the end of October, the last date for which Vanguard gives us data, Apple (AAPL) made up 21.5% of its total market cap value. Microsoft (MSFT) made up the next 16.7% of VGT compared to the 4.70% it made up of the Total Stock Market.

So that though VGT holds 330 stocks, those two stocks alone now make up 38.2% of its entire value. Given how magnificently those two stocks have performed recently, they alone could easily explain VGT's impressive performance.

But wait, Apple makes up more than a fifth of the value of VGT compared to the 5.1% it represents of the Vanguard Total Stock Market Index. Microsoft's share of VGT is 3.5 times as much as its share in the broader market indexes. With that much more Apple and Microsoft, you might expect to see 3 or 4 times more outperformance for VGT, not just twice as much. So that leads us to ask what else is in VGT?

Some Major Tech Stocks are Missing and Some Odd Ones are Included

A casual glance at these top 25 holdings reveals some surprising omissions. Are we really looking at an "Information Technology" index that does not hold Alphabet (GOOG) (GOOGL)? And where is Amazon, whose AWS is the largest of all the cloud service providers, raking in over $10 billion a quarter? For that matter, where is Facebook?

To learn why this is true, we have to look at how Vanguard picks the stocks it holds in this ETF.

Vanguard describes the ETF by saying that it tracks "the performance of the MSCI US Investable Market Information Technology 25/50 Index, an index of stocks of large, medium-size, and small U.S. companies in the information technology sector, as classified under the Global Industry Classification Standard (GICS)." It then explains that the GICS Technology sector is made up of companies in the following three general areas: internet services and infrastructure companies, technology hardware and equipment, and semiconductors and semiconductor equipment manufacturers.

VGT's Index Follows A Simplistic, Outdated Definition of Information Technology

The MSCI US Investable Market Information Technology 25/50 Index is only used for this one Vanguard ETF. No other fund company uses it. I was not able to find any details about how this index is constructed on the MSCI website. But it really doesn't matter. Because no matter what methodology is used to select the broader US market index from which the Information Technology stocks are selected, the critical gating factor here is that this index selects Technology stocks using another of MSCI's products, The Global Industry Classification Standard, or GICS.

The GICS methodology assigns every stock in any market worldwide to one of its sectors. These sectors are then broken down into two more levels, Industry Groups and Industry, in a hierarchical manner. You will immediately recognize these GICS sectors because they are constantly referred to by analysts who treat them as entities that are often graphed and analyzed. When the financial media proclaim that Energy is recovering or Financials are stressed by a low interest rate environment, those terms are referring to these GICS sectors.

This is the graphic MSCI provides that lays out the hierarchy it has created. I have highlighted the branch that applies to Information Technology.

Source: msci.com

The problem is that this 20th Century hierarchical structure fails in the hyperlinked world of today. It assumes that a company fits into a single sector and industry. When faced with near-trillion dollar mega cap companies that operate across industry lines, it fails because it has no choice but to assign a single sector, industry group, and industry to that company and its stock.

It is the way that GICS has pigeonholed Amazon, Facebook, and Google that explains why they are missing from this Information Technology ETF. They have not been labeled as belonging to the "Information Technology" sector, that sector whose very name reeks of the early 1980s. I suppose we should be grateful it isn't called the "Data Processing" sector.

As we learned when we looked at the Consumer Discretionary and Consumer Staples ETFs. Amazon is assigned instead to the Consumer Discretionary Sector, subgroup: Retailing. Industry: Internet & Direct Marketing Retail. This category probably made sense 20 years ago when Amazon mostly sold books. But it no longer works when the company's major source of earnings is AWS cloud services.

A Major 2018 Switcheroo Hit All ETFs Following MSCI or S&P Global Indexes

To understand what happened to Google and Facebook, you have to do a bit more research. There is a puzzling footnote that you will find appended to the legend on VGT's performance graph labeled, "Information Technology Spliced Idx*". The footnote defines that benchmark as:

MSCI US Investable Market Information Technology Index through February 26, 2010; MSCI US Investable Market Information Technology 25/50 Index through May 2, 2018; MSCI US Investable Market Information Technology 25/50 Transition Index through December 2, 2018; MSCI US Investable Market Information Technology 25/50 Index thereafter."

I was puzzled as to why there was a transition index used between two indexes that have the identical names. But a little research turned up the fact that in 2018, S&P Global and MSCI decided there were too many stocks in the Information Technology sector and created a new sector: Communication Services.

They then moved Alphabet and Facebook (FB), which had been in the Information Technology sector up until then into this new Communication Services sector, Media and Entertainment Industry Group, Internet Content & Information Industry. You can immediately see the problem. The one-sector-per-company rule means that we have to treat these enormous companies as if they did one thing and, in the case of Alphabet, ignore the role that cloud services, Android, and dozens of other Google businesses play in its business.

eBay (EBAY), too, was an Information Technology stock until in 2018 it was also moved not into the Communications Service Sector, but into the Consumer Discretionary Sector, Industry group: Retailing, Industry: Internet & Direct Marketing Retail. This sounds like it would put it into the same category as whatever company runs the Book-of-The-Month Club.

And Tesla (TSLA), of course, despite the heavy use of computer technology in its self-driving cars is another Consumer Discretionary company, like Amazon. This one placed in the Automobile subclassification.

The change in the Sectors that created the new Communication Services Sector and moved around the Mega Cap previously Tech companies became official on September 24, 2018, which is why Vanguard had to have a "transition index" that year as it moved those stocks out of VGT.

VGT's Advantage Over QQQ Dropped after 2018

VGT was not alone in having three of its big, well-known tech stocks wrested from its index. This major rearrangement of the sector definitions meant that every ETF that used S&P Global or MSCI's sectors, including the Technology Select Sector SPDR Fund (XLK) had to get rid of several of its largest cap, most profitable stocks, replacing them with nothing. Only QQQ was unaffected as it defines Tech stocks using a different and more sensible definition of "technology stock" than does GICS.

So, for the investor looking to buy VGT today, it means that when you look at those pretty performance graphs from 2004 through December of 2018 and think you are looking at the past performance of the ETF you will be buying now, you will be misled. Alphabet, Amazon, and Facebook contributed heavily to VGTs strong, past outperformance, but they won't be, going forward.

Even so, the devastation to ETF holders that could have been caused by the dropping of Amazon, Google, and Facebook from VGT as their share prices were soaring was masked to some extent by the huge gains made by Apple and Microsoft, which now played a far larger role in VGT's price action, now that the other huge cap stocks were gone. VGT still outperformed QQQ after December 2, 2018, when the index changed when QQQs holdings stayed steady.

But over the two years since the sector changes were made, the margin of VGT's outperformance of QQQ dropped significantly. In the two years before the index change, that outperformance was 10.5% in the two years following the index change, it was only 6.49%.

VGT Compared to QQQ Dec 1, 2016, to Dec 4, 2018

Source: Morningstar

VGT Compared to QQQ Between December 3, 2018, and Now

Source: Morningstar

VGT Is Still a Good Investment - But Watch Out For More Sector Redefinitions

I currently own VGT and I have been happy with its progress. I don't know enough about technology stocks to pick winners on my own and I did want to tilt a bit toward technology because I do think it will continue to outperform over the long term, even if it sinks temporarily during a correction in the nearer future. It still has given me very satisfying gains, even if those gains aren't what they might have been if they had been able to hold onto Amazon, Google, and Facebook.

I base my belief that it will continue to perform very well not on a valuation approach - which is how I usually evaluate the stocks I buy - because most of the stocks that dominate VGT and decide its price are highly overvalued based on their expected future rate of growth. But tech has defied sober valuation techniques for so long that applying reasonable valuations to mega cap tech stocks seems foolish. VGT is all about those biggest tech stocks and it also benefits when small stocks like Zoom (ZM) turn into much larger stocks overnight. No matter what happens to today's Mega Cap Tech darlings, it is very likely that new ones will arise and keep the ETF's total return growing.

So VGT looks like a safe hold to me right now, though if you are buying in for the first time you might do better to wait for a bit more correction in the frothier Tech stocks. But maybe not. Over the long term, investors aren't likely to lose their love for tech anytime soon, and no matter how many underwater pundits declare that Value is rotating upwards and Tech is on the way down, timing tech right has always been extremely difficult. Even if it is a bit inflated, if you buy VGT now and hold it for the next decade, you probably will do well.

But that said, what happened in December 2018 reminds us there is always the chance that some nameless, faceless committee somewhere will redefine the sectors again and decide that Microsoft with its games is an Entertainment stocks and Apple's phones and heavy investment in selling content makes them really belong with the Communication Services sector and move them out of the Tech ETF. Or they may decide they need even more sectors and split half the Technology Sector into another different top level sector and will you lose half the stocks you currently own in the ETF. It might not happen, but it could.

This is why I am becoming convinced, the more that I look deeply into the murky depths of ETF index construction, that ETFs that slice the total market into sectors, styles, and factors are often not what the buyer thinks they are getting. Buying anything but broad market index ETF like the Vanguard Total Stock Market ETF (VTI) or an S&P 500 ETF (VOO) or (SPY) exposes you to the risk of having some faceless functionary somewhere tweak something that can severely impact the stocks held by your ETF.

Going forward, knowing what I have learned writing this series about ETF indexes, I am unlikely to buy any more ETFs that use the GICS Sector definitions to pick stocks when I want to overweight that sector. Their sector definitions are too hierarchical - too 20th century. Until they get smart and design a more networked classification system, where a single stock can be defined as belonging to multiple sectors, industry groups, and industries when its business operates in multiple sectors, industry groups, and sectors, the GICS classification system will continue to be flawed, no matter how much they tweak it.

And though I am not at all unhappy with VGT, I would much prefer an actively chosen (not necessarily actively managed) Tech ETF index with a lot of holdings and a low expense ratio, where though algorithms manage the day to day activity of the Index, human beings with functioning brains decide which companies go into that index using good old fashioned common sense.

A Final Note

You should also keep the poor job these sector classifications do in mind when you see pundits proclaiming that some sector is getting hot or slowing down. Tech is not the only sector that contains way too many companies that are classified in sectors that really don't fit their current business models.

Psycho Analyst

Though I have done quite a few different things over the course of a long life, I am best known as a writer of bestselling books about business and health. My success has come because I am a very curious person who doesn't just follow the herd and trust whatever the experts tell us to believe. I do my own research. I collect the facts, look at them objectively, and draw my own conclusions. Over the years, I have been amazed at how much of what everybody "knows to be true" is based on poorly designed studies, many of them impossible to replicate. I approach Investing with the same open mind, challenging the orthodoxies that attract the herd, studying how things really work, and doing my best to come up with an approach, based on facts, that works for me and would appeal to those who find thinking worthwhile.

Analyst’s Disclosure: I am/we are long VGT. 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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