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Cloud Computing ETF Aims For The SKYY, But Misses

Summary SKYY delivers exposure to companies in the cloud computing space. The definition of a cloud computing company includes everything from technology providers to game companies that use the technology. The result is a broad technology portfolio that lacks the pure exposure investors may be after. Cloud computing is transforming the information technology landscape. It offers companies numerous advantages, including enhanced agility and dynamic scalability as well as the potential for significant cost savings. This technology has been growing rapidly and that pace is expected to continue. Investments in key strategic areas like enterprise mobile, big data analytics and information security is expected to increase significantly over the next few years. Analysts at Market Research Media estimate that the global cloud computing market will grow 30 percent compounded annually over the next five years to reach $270 billion. This likely growth in the cloud-based computing sector offers investors an opportunity to reap tremendous rewards. First Trust ISE Cloud Computing Fund The First Trust ISE Cloud Computing Index ETF (NASDAQ: SKYY ) seeks to provide results that generally correspond with the price and yield of the ISE Cloud Computing Index. This exchange-traded fund normally invests at least 90 percent of assets in common shares or depository receipts issued by companies contained within the index. The ISE Cloud Computing Index is designed to provide a benchmark for investors tracking companies principally engaged in the cloud computing industry. To be included in the benchmark index, securities must be listed on a global exchange and be engaged in a business activity providing, supporting or utilizing cloud computing services. Securities are classified as pure cloud computing companies and non-pure play companies whose focus is outside the cloud computing space but still have a significant exposure to the industry. The sector also includes technology conglomerates that may indirectly utilize or support cloud computing technology. In addition to a 10 percent allocation in technology conglomerates, managers use a calculation based on the relationship between the market capitalizations of the pure and non-pure play companies to determine their respective allocations. The underlying index then uses a modified equal dollar-weighted average approach when balancing the portfolio semiannually. SKYY is a three-star Morningstar rated ETF with $468.24 million under management. As of October 4, the fund had a 94 percent exposure to domestic equities and a 6 percent allocation of foreign shares, mostly in developed Europe. Weighted heavily towards the technology space, SKYY also held a small position in consumer cyclical and communications services companies. The ETF had a 33 percent allocation to giant cap companies as well as a 22 percent and 35 percent exposure to large and mid-cap shares. There is also a 6 percent and 4 percent allocation to small- and micro-cap shares. The fund’s average market capitalization is $27.7 billion. The portfolio has a P/E ratio of 24 and a price-to-book of 3.8 according to the issuer’s website . The portfolio’s top 10 holdings comprise 43 percent of assets. Companies held in the fund include Amazon (NASDAQ: AMZN ), Google (NASDAQ: GOOG ), Netflix (NASDAQ: NFLX ), Facebook (NASDAQ: FB ) and Open Text (NASDAQ: OTEX ). As the top holding, Amazon has been a driving force behind the fund’s performance in 2015. While predominately known as an e-commerce site, Amazon generates more than $4.5 billion in revenue from its cloud-based services. Although cloud services account for less than 10 percent of Amazon’s total revenue, it is the fastest growing segment of the company’s overall business. The Amazon Web Services (AWS) business unit grew 49 percent in 2014 and 81 percent during the second quarter of 2015 on an annualized basis compared to the 26 percent growth in North American retail sales. While the company’s retail operation is losing money, AWS is very profitable. At 21 percent, it provides significantly higher profit margins when compared to other business units. The profit margin for AWS has continued to rise despite price competition from competitors like Google, IBM (NYSE: IBM ) and Microsoft (NASDAQ: MSFT ). One of the first to enter the cloud computing space, Amazon has a lead on its competitors. To stay ahead, it is expanding services to include tools for analyzing data stored on their servers, building new online software applications and increasing storage space. Based on a belief that the future is in the cloud, Amazon has been investing billions of dollars building and expanding centralized data storage centers. Eventually, Amazon’s cloud computing unit may become the largest business segment within the company. SKYY’s 1- and 3-year total returns are 6.29 percent and 13.27 percent respectively, as of October 4, which compares to the technology category returns of 4.92 percent and 14.93 percent over the same periods. SKYY has a 3-year beta and standard deviation of 1.08 and 14.09. The equivalent period ratings for the science and technology category are 0.98 and 13.87. The ETF’s net expense ratio of 0.60 percent is slightly higher than the category average of 0.57 percent. This chart shows the performance of SKYY and the Technology Select Sector SPDR ETF (NYSEARCA: XLK ). The two are highly correlated as one would expect, but the relative can be substantial. The second chart, the price ratio of SKYY versus XLK, shows that performance has swung between under- and outperformance, but without any consistent pattern. (click to enlarge) (click to enlarge) With a lot of big Internet names in the top holdings, it’s worth considering an Internet fund as well. Here’s the price ratio of SKYY versus the First Trust DJ Internet Index ETF (NYSEARCA: FDN ), which has substantial overlap in holdings. The funds track closely in terms of performance, tied as they are to the overall technology sector, but FDN has been a more consistent winner. (click to enlarge) Outlook As sometimes happens with sub-sector funds, the definition of a cloud computing company is stretched to create a full portfolio here, with several companies that are cloud users rather than backbone companies that provide the technology. With cloud services becoming a major part of the Internet business, it is also becoming difficult to separate out pure play companies. The result is a portfolio that looks a lot like an Internet or broader technology fund. Performance aside, the big strike against SKYY is the large weighting of familiar Internet companies found in most broad technology funds. SKYY isn’t offering the unique exposure that investors may think they’re getting. Investors looking for pure exposure to cloud computing would be better off holding individual stocks, and sticking with Internet or broad technology funds for the rest of their technology exposure.

HACK Or CIBR? Choosing A Cybersecurity ETF

Summary HACK is the more expensive fund, with greater liquidity and more of a pure play portfolio. CIBR is the cheaper fund with greater exposure to larger companies, resulting in slightly less volatility. HACK and CIBR have proven to be considerably more volatile than the broader technology sector. High-profile data breaches have affected companies like Ashley Madison, Sony (NYSE: SNE ), Starbucks (NASDAQ: SBUX ) and Target (NYSE: TGT ). There have also been reports of cyberattacks against government agencies, including the Department of Defense. Organizations around the world are stepping up their efforts to update their protocols and technology to restrict unauthorized intrusions and the theft of sensitive information. As a result, analysts expect spending on cybersecurity to be a growing line item for all manner of organizations. This has led to increased interest in cybersecurity-related stocks and in 2015, cybersecurity stocks had produced some of the market’s best year-to-date returns before the August sell-off. Rather than trying to single out individual firms, two exchange-traded funds, the PureFunds ISE Cyber Security ETF (NYSEARCA: HACK ) and the First Trust Nasdaq CEA Cybersecurity ETF (NASDAQ: CIBR ), offer investors broad exposure and diversification across this niche in the information technology industry. PureFunds ISE Cyber Security Established in November 2014, HACK was the first ETF created to track the cybersecurity industry. The fund’s goal is to provide investment returns that generally correspond to those of the ISE Cyber Security Index before fees and expenses. The index tracks the performance of domestic and international companies that provide cybersecurity or for which cybersecurity is a key driver in their overall business model. The $1.29 billion fund has a 71.5 percent exposure to domestic stocks and a 28.5 percent allocation to foreign securities, mainly Greater Europe and the Middle East. The fund’s largest exposure is to mid-, small- and micro-cap companies. First Trust Nasdaq CEA Cybersecurity The First Trust Nasdaq CEA Cybersecurity ETF began trading on July 7, 2015. CIBR seeks to replicate the performance, before fees and expenses, of the Nasdaq CEA Cybersecurity Index. The benchmark index includes common stocks and depository receipts of companies classified as engaging in cybersecurity according to the Consumer Electronics Association (CEA). The fund intends to hold a position in each security contained within the index. CIBR has a 28 percent allocation to large cap stock as well as a 38 percent allocation to mid-cap and 22 percent exposure to small-cap stocks. CIBR has a 67 percent exposure to domestic securities and a 33 percent exposure to foreign issues, mainly the United Kingdom, the Middle East and Emerging Asia. Fund Differences Although the funds have similar goals, there are differences between the two ETFs. These subtle nuances may result in one fund, rather than the other, being more suitable for your individual portfolio. The first difference is the construction of their underlying benchmark indices. HACK utilizes the ISE Cyber Security Index as its benchmark. This index focuses on companies that develop hardware and software for safeguarding networks, websites and files. CIBR tracks the Nasdaq CEA Cybersecurity Index, which includes companies engaged in building, implementing and managing security protocols for public and private networks, computers and mobile devices. While the indices are similar, they differ in the size of the companies held within the portfolio, their market liquidity and the manner in which the index is weighted. CIBR has a market cap minimum of $250 million and an average three-month trading volume of $1 million. HACK lowers the market cap requirement to $100 million and does not have a trading minimum. While the ISE Cyber Security Index of HACK uses a modified equal weighting methodology, the Nasdaq CEA Cybersecurity Index backing CIBR utilizes a modified liquidity-weighted technique. The result of these differences is HACK has more assets in smaller companies that are more easily categorized as pure plays in the industry. This focus creates the potential for higher volatility and risk associated with owning small and micro-cap stocks. A second difference is portfolio composition. The top five holdings for HACK are Fortinet (NASDAQ: FTNT ), Imperva (NYSE: IMPV ), Trend Micro ( OTCPK:TMICY ), Proofpoint (NASDAQ: PFPT ) and Juniper Networks (NYSE: JNPR ). CIBR’s top holdings include Qihoo 360 (NYSE: QIHU ), Palo Alto Networks (NYSE: PANW ), Cisco (NASDAQ: CSCO ), FireEye (NASDAQ: FEYE ) and NXP Semiconductors (NASDAQ: NXPI ). With a heavier tilt towards software names, HACK is more of a pure play. Overall, HACK has a little over 10 percent of its portfolio in stocks not held in CIBR, while CIBR has about a third of its holdings in stocks not held by HACK. Beyond owning a more differentiated portfolio, CIBR is a bit more diversified since it has more individual holdings within its portfolio. Due to the size of the industry and the companies available for investment, both funds also hold some large caps to fill out their portfolios. As a result, both funds hold large caps such as Cisco Systems and Juniper Networks that are not pure plays on cybersecurity. CIBR doesn’t have a long history and has tracked closely with HACK since inception. Since the inception of HACK, it has outperformed the Technology Select Sector SPDR ETF (NYSEARCA: XLK ), 0.60 percent gain versus a 2.10 percent loss for XLK through September 30, but it comes with a high degree of volatility. In September, XLK fell 1.4 percent, but HACK and CIBR fell 6.9 percent and 3.6 percent, respectively. Since the inception of CIBR in July 2015, XLK is down 1.7 percent, versus a 15 percent drop in HACK and a 12.5 percent decline in CIBR. The recent negative returns may be a reflection of the downturn in the overall market rather than the cybersecurity industry, but it reflects the type of volatility investors can expect. The chart below shows XLK in black. The red line shows the price ratio of HACK versus XLK (a rising line indicates outperformance), while the blue line shows the price ratio of HACK versus CIBR. (click to enlarge) With a short history, one cannot make a long-term prediction about relative performance, but to date, the funds are behaving as expected given their construction. When the technology sector is rising, HACK outperforms XLK. When the technology sector is falling, HACK and CIBR underperformed. HACK also underperformed CIBR when the technology sector declined. Outlook HACK’s emphasis on smaller, faster-growing firms makes it more of a pure play on this market niche. Smaller cap stocks often provide better returns during bull markets and worse returns during a bear market and thus far, performance has been as expected. Investors in cybersecurity stocks can look forward to a roller coaster ride, but HACK will likely deliver bigger gains and losses. By concentrating on larger companies due to stricter liquidity requirements, and greater diversification, CIBR focuses on more established names that may make the ETF better suited for more conservative investors – although even CIBR will be far more volatile than the average technology fund. With an expense ratio of 0.60 percent, CIBR also has a lower cost than the 0.75 percent expense ratio of HACK. Weighing the two options, HACK is the better choice for aggressive investors looking for as much pure play exposure as possible as well as more short-term oriented trades. CIBR would be a little better fit for an investor looking to shift some technology exposure into cybersecurity, if only for the lower expense ratio compared to HACK. Both funds have more than adequate daily volume, but HACK has more than 10 times the daily dollar volume of CIBR, making it the more liquid option for large investors.

3 Of Seeking Alpha’s Best, Part II

Summary As a hedge fund manager, who do I think is worth following on SA? 3 (more) writers I take seriously and think you should too. This is the second in a continuing series. In Part I , I looked at three of Seeking Alpha’s best contributors. In this sequel, I offer three more worth following. They all happen to be hedge fund managers and friends of mine. Whitney Tilson Whitney Tilson founded and manages Kase Capital and he wrote The Art of Value Investing and More Mortgage Meltdown . He has been a valuable contributor to Seeking Alpha, especially on the short side. I want to highlight some of his short ideas that I found most compelling at the time. He has been one of the most consistent voices on the issue of World Acceptance (NASDAQ: WRLD ) since publishing his compelling investment thesis, World Acceptance: A Battleground Stock I’m Short . One of the next up was K12 (NYSE: LRN ). Shorting can be a painful waiting game, but he did not have to wait long on An Analysis Of K12 And Why It Is My Largest Short Position . For more on LRN, he also published this slide presentation. Whitney is probably best known on Seeking Alpha for the quality (and quantity) of his devastating work on Lumber Liquidators (NYSE: LL ), starting with My Analysis Of Lumber Liquidators’ Updated Guidance . Here was my reaction to the 60 Minutes episode on LL: Whitney, Well done and congratulations! It was a terrific and compelling piece. The LL founder was evasive and deceptive. I replayed his comments several times. He knew . This is an important and favorable development for short sellers. Shorting and exposing truth is not a conflict of interest – it is a confluence of interest. Ethics involves not lying/cheating/stealing; we cannot rely on the cheap substitute of listening only to people with nothing at stake. Modern investment management has often tried to rely on both thinking substitutes and ethics substitutes. Thinking substitutes such as diversification and volatility minimizing have fared poorly but have not yet been abandoned. Ethics substitutes (“listen to me because I promise that I have at no time and in no place ever even thought about doing with my own money what I now tell you to do with yours”) have fared just as badly but are still in daily use. Your 60 Minutes segment is a big step towards real morality in business and investing. Sure, you are invested in the outcome, but you are invested because your view – and the evidence you lay out – supports that outcome. That is a bigger deal than whatever ultimately happens to LL. Finally, it serves the interest of free enterprise and free trade to have markets self-policed. Pieces such as this can protect markets from inevitable calls to have endless central planning and control. The best way to counteract the self-interest of cheaters is with the interest of short-sellers. While the government may have the resources, it never seems to have the speed to act when it counts. You have both and did something about it. Chris DeMuth Jr. InterOil (NYSE: IOC ) is one that we have both followed for a long time. I wrote about our IOC short on my blog and in InterOil Increases Production… Whitney’s thinking was helpful to the short thesis, including his article Why There’s More Downside To Come For InterOil . When he wrote The Beginning Of The End Of The 3D Printing Bubble… …it was, in fact, the beginning of the end of the 3D printing bubble. Unilife (NASDAQ: UNIS ) has been a favorite topic of mine on my blog here and here , as well as in an article on my favorite pairs trade. While I do my own work, Whitney’s contribution to the topic further solidified my thinking on this company. Ben Axler Ben Axler founded Spruce Point Capital, a long/short hedge fund. He has exposed over $1.0 billion of alleged listed frauds on NASDAQ and the NYSE. Want a great short idea? Read about Caesarstone Sdot-Yam (NASDAQ: CSTE ) in Ben’s article: Caesarstone: A Counter To The Bull Thesis On Quartz Countertops Suggests 40-75% Downside . It has declined by over 20% since publication, but remains expensive and risky. Value investors, skeptics, and debunkers should follow him here on Seeking Alpha and here on Twitter. You can also learn more about his hedge fund and other investment ideas on Spruce Point’s site . He was kind enough to join us for our last biannual ideas dinner in New York City last month where he gave us a devastating preview of what would happen to CSTE. His update is available here: Downgrading Caesarstone On Concerns About Its Capital Expenditure Accounting And Management’s History At Tefron . Andrew Walker A portfolio manager at Rangeley Capital, Andrew is a long-time friend. We have collaborated on investment ideas that we’ve posted on Seeking Alpha as far back as our early work on ALJ Regional Holdings ( OTCPK:ALJJ ), which I wrote about here . If you have an hour to learn about investing in small caps, you should listen to this interview. Additionally, I describe our work together here . Next year, we will launch our new Special Opportunities strategy that will focus on small-cap equity opportunities including special situations. Andrew has been chosen as the portfolio manager to run that new endeavor. He is exactly who I always wanted to run such a strategy. I will follow the example of Charlie Munger, who says that: Berkshire (NYSE: BRK.A ) (NYSE: BRK.B ) is run with decentralization almost to the point of abdication. While I plan to do the same at Rangeley, this requires the perfect people to manage specific businesses. Happily, I have the right people. Meanwhile, if you would like to hear more of Andrew’s investment ideas, he and I will both be speaking at an upcoming conference focusing on microcap investing. Conclusion These are the types of people I rely upon. Charlie Munger said that: The highest form that civilization can reach is a seamless web of deserved trust – not much procedure, just totally reliable people correctly trusting one another. This is what my web of deserved trust looks like. Who is in yours? Who should I add to mine? I intend to keep this series going, so please let me know if there is anyone who writes on Seeking Alpha who should be included in a future edition. I am always in search for idea candidates for Rangeley Capital as well as candidates for both new submissions and new members for Sifting the World . Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.