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ETF Specialist

Cheap Exposure to the U.S. Telecom Firms

For investors with a strong conviction about the fortunes of telecom firms, this ETF's low fees make it an appealing option.

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 Vanguard Telecommunication Services ETF (VOX) offers concentrated exposure to the U.S. telecom industry. This exchange-traded fund holds 31 U.S.-domiciled telecom companies, including telecom service providers, one tower operator, and an IT services firm (inContact (SAAS)). As a result of its market-capitalization-weighting approach, this ETF is very top-heavy; the top-10 holdings account for the vast majority of the portfolio. And its top two holdings ( AT&T (T) and  Verizon Communications (VZ)) make up nearly half of the fund's assets.

Large telecom firms have tended to offer above-average dividend yields and may be attractive to income-oriented investors. This fund's dividend yield (3.5% as of Jan. 31, 2016) and annual payout have displayed some volatility during the past decade. Some telecom firms, such as AT&T and Verizon and their predecessors, have had stable or rising dividends for decades. However, dividend payouts have been less consistent among some of the smaller players, owing mostly to high amounts of financial leverage. CenturyLink (CTL) and  Frontier Communications (FTR) have made big dividend cuts and  Sprint (S) eliminated its dividend a few years ago.

Although many large telecom firms are not especially volatile, this fund also holds telecom firms across all parts of the market-cap spectrum. In fact, large-cap telecoms make up 58% of this fund's assets, while mid-cap telecoms constitute another 12.5% of assets. Of the 29% of VOX's assets that are devoted to small-cap companies, a clear majority (some 18% of the fund's total assets) is invested in micro-cap names. That small-cap stake has had the effect of offering diversification for a fund that has large weightings in its top two holdings. During the past five years, VOX has had a standard deviation of 11.9% compared with 11.9% for the S&P 500 and 14.2% for a competing iShares telecommunications ETF. VOX is less volatile than the iShares offering because it has far greater weightings in AT&T and Verizon.

Fundamental View
The U.S. telecom sector continues to evolve. Households continue to exchange land lines for cellphones, while cable players keep invading telecom firms' turf, offering Internet access and even phone service. More cable consolidation is occurring. And big cable companies (which are not held in this ETF) are boosting network quality and trying to take market share from telecom rivals in the less attractive residential fixed-line portion of the market. Wireless customers increasingly use their phones for data instead of voice, although voice is where telecom firms up to now have reaped the most revenue. Telecom now is a hypercompetitive environment, as large players AT&T and Verizon offer tiered data pricing while other providers offer straight unlimited data plans. At least for now, business fixed-line telecom service remains a stable revenue source for telecom firms.

Despite all these changes, the telecom industry is, paradoxically, fairly mature. Most basic infrastructure already is in place, capital spending has plummeted as a percentage of sales for many telecom carriers, and many firms now generate hefty cash flows and use excess cash to boost dividends, make acquisitions, and buy back shares. Some smaller firms that have had heavier debt loads have worked successfully to pay down debt.

A major catalyst affecting many telecom firms is deal activity. While AT&T and Verizon previously had consolidated much of the industry, a new round of consolidation is ongoing. Driving this latest round are an interest in expanded service offerings, desires by midsize players for greater economies of scale, the ability to better compete with Verizon and AT&T, and scarce spectrum licenses. Major telecom deals include AT&T's push to expand the boundaries of its offerings through its acquisition of satellite TV provider DirecTV, and Verizon's desire for mobile advertising platforms through its acquisition of AOL. Smaller telecom deals have taken place as well. It's not clear how much more consolidation is ahead from actual telecom service providers, as the Federal Communications Commission is forcefully working to preserve existing competition. That would effectively prevent the pairing of Sprint and  T-Mobile US (TMUS)--which seem increasingly unable to compete on their own--to better compete with AT&T and Verizon. Even so, a non-U.S. firm, such as  America Movil (AMX) or a satellite firm like  DISH Network (DISH) could pair up with T-Mobile. Sprint, which makes up about 1.4% of the fund, at this point is a highly speculative investment, with the firm burning cash at an alarming rate and shareholders increasingly at the mercy of majority shareholder Softbank.

For the most part, M&A activity is a positive for the industry. For investors, however, consolidation is a mixed bag and probably is neutral. AT&T and Verizon currently have industry-leading margins by a wide amount. If firms in the next tier consolidate and strengthen, it could be a modest negative for those two titans as smaller firms would be less likely to be sources of easy market share gains. At the same time, consolidation would help those smaller firms improve their cost structures and move up toward acceptable profitability over the long term.

Portfolio Construction
VOX tracks the MSCI US Investable Market Telecommunication Services 25/50 Index, which contains both fixed-line and wireless telecom service provider stocks plus a pair of tower operators. Integrated telecom services operators comprise 69% of VOX's assets; the remainder is devoted to alternative carriers (19% of assets) and wireless telecom service providers (12%). VOX's index weights its holdings by market cap, which results in very low turnover. The index also caps its largest holdings' weightings. At each rebalance, its top two holdings are not permitted to exceed 22.5% of the index each.

Fees
VOX's 0.10% expense ratio is less than one third the fee that rival  iShares U.S. Telecommunications (IYZ) charges. However, IYZ is much more liquid than the Vanguard fund.

Alternatives
For similar domestic exposure to the telecom sector, IYZ (0.43% expense ratio) charges much more than VOX but has much smaller weightings in top holdings AT&T and Verizon.

Both the Dow Jones index that IYZ tracks and the MSCI index that VOX tracks cap the weightings of their largest constituents for diversification. However, the MSCI index's caps are much higher, which is why AT&T and Verizon's weightings are so much higher in VOX. Those two titans make up between 12% and 13% each of IYZ's assets. VOX's index caps its top two holdings' weightings at a maximum of 22.5% each. Because AT&T and Verizon's market caps dwarf those of VOX's other holdings, those two powerhouses routinely bump up against (and often temporarily exceed) that 22.5% cap. IYZ has more of a small- and mid-cap tilt than VOX. As a result, IYZ is slightly more volatile than VOX.

Fidelity MSCI Telecommunication Services ETF (FCOM) is a very inexpensive ETF, with a 0.12% fee. However, FCOM has fewer assets than competing ETFs, which could make it more expensive to trade. FCOM tracks a slightly different index--the MSCI USA IMI Telecommunication Services 25/50 Index—while VCR tracks the MSCI US Investable Market Telecommunication Services 25/50 Index. The indexes are very similar, with nearly identical weighting schemes, similar numbers of holdings (VOX holds 30 companies, while FCOM owns 32), and minimal differences in holdings. (For example, VOX holds Zayo Group Holdings (ZAYO) while FCOM doesn't; meanwhile, three of FCOM's holdings aren't found in VOX: Straight Path Communications (STRP), Boingo Wireless (WIFI), and NII Holdings (NIHD).) Fidelity customers with a minimum balance of $2,500 can buy FCOM commission-free. Fidelity may charge a trading fee to those who sell after a short-term period (30-60 days); customers who own for longer periods are not subject to any such fee.

Those seeking exposure to global telecom titans, such as  Vodafone (VOD) and  Telefonica (TEF), should consider  iShares Global Telecom (IXP) (0.47% expense ratio). AT&T constitutes 19% of IXP's assets, and Verizon makes up another 17.5% of assets. Apart from U.S. companies, which make up about 40% of IXP's assets, IXP focuses most on developed foreign markets, with emerging-markets companies making up about 10% of its assets. Historically, IXP has posted lower volatility than domestically oriented telecom ETFs.

In general, major domestic telecom ETFs have highly correlated performance. VOX's performance has shown a 97% correlation to IYZ's performance during the past 10 years. VOX's performance has been less correlated (83%) to IXP's performance during that same interval.


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Robert Goldsborough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.