This ETF lets you track tech chip sector – but it’s very boom and bust

A new semiconductor ETF has caught Tom Bailey’s eye. He explains why by outlining the investment case. 

Semiconductor chips are the foundations of the digital economy. These small chips are an essential technology that enables anything digital or computerised.

Most notably, they are vital for computers and mobile phones. However, as the rest of the economy “digitises” their use will expand even more. Everything from cars and refrigerators to new medical devices are computerised and require semiconductors to work. Likewise, future industries such as automated manufacturing, artificial intelligence and the Internet of Things are going to be reliant on these chips.

It is no wonder, then, that the semiconductor industry is booming. Watchers of the stock markets will have seen the strong recent performance of Taiwan Semiconductor Manufacturing (NYSE:TSM)and Nvidia (NASDAQ:NVDA), alongside other companies in the sector. Observers of geopolitics will have seen the role that the import and export of semiconductor chips have played in the US/China trade war.

Chip-tracking ETF

It sounds like an attractive industry to get exposure to. So, as you would expect, there is an ETF for it, the recently launched VanEck Vectors Semiconductor ETF (LSE:SMH).

This ETF tracks the MVIS US Listed Semiconductor 10% Capped Index, composed of the 25 largest and most liquid US-listed semiconductor firms.

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The index is a so-called pure play index, meaning it only includes companies that derive most of their earnings from the production and sale of semiconductors. To be included, companies must also have a market capitalisation of over $150 million and be listed on a US stock exchange.

The requirement for a US listing does not mean that it is only US companies in the index. Indeed, the biggest constituent is currently Taiwan Semiconductor Manufacturer. Also in the top 10 is Dutch company ASML Holding (NASDAQ:ASML).

No Chinese companies

However, the restriction to US listings does pose a potential problem. China is an increasingly important player in semiconductor manufacturing.

China is home to an increasingly advanced tech industry, producing some of the world’s leading telecoms equipment and electric cars, among other things. Semiconductors are a vital input. Historically, the country has imported most of the chips it needs and China is said to spend more on importing chips than oil.

However, the recent worsening of relations with the US showed how vulnerable this made Chinese industry. Under Donald Trump, the US banned the sale of chips to some of China’s most important tech companies, most notably telecoms firm Huawei.

As a result, China now aims to become self-reliant in semiconductors, cultivating its own domestic producers. Given the geopolitical context, it is unlikely that many Chinese semiconductors will opt for a US exchange listing. If China is successful in producing its own semiconductor suppliers, this ETF, under current index rules, misses out on an important part of the market.

Considering China is such a big importer of chips, this could have a major impact on the fortunes of the companies currently in the index. However, whether China’s domestic producers can actually match the likes of Taiwan Semiconductor Manufacturing, Nvidia or ASML is yet to be seen.

Watch your weights

The VanEck Vectors ETF caps holdings at 10%. This means the ETF is regularly rebalanced to bring the weightings back to 10%.

Currently, the world’s leading chip maker is, by far, Taiwan Semiconductor Manufacturing. As a result, it currently has a weighting of around 13%. While this will revert to 10% when rebalanced, that still gives it a fairly substantial weighting.   

This isn’t necessarily a problem – it is a great company, by most accounts. But investors should be wary of overlap. Currently, Taiwan Semiconductor Manufacturing is also the biggest weighting in the MSCI Emerging Markets index, at just over 5%. It also has a weighting of almost 1% in the MSCI ACWI index and almost 4% in the MSCI Asia Pacific index. Many active emerging market funds are also overweight this stock, holding more than the MSCI Emerging Markets index.  

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This means that investors who already own some of these funds may already have a fair amount of exposure to this company, which will only grow by also investing in the semiconductor ETF. Again, this isn’t necessarily a problem. Investors may be happy to have a relatively high exposure to the company. It also entirely depends on the weighting of each fund in the portfolio. But it is still something investors should be aware of. 

Boom and bust industry

Anyone looking to invest should also be aware that the industry is highly cyclical, periodically going through booms and busts.

The cycle is the result of supply and demand. The industry goes through periods when demand for semiconductor chips is strong, with output failing to keep pace, resulting in prices rising.

This is currently the case. There is a global shortage of chips, with demand particularly strong for use in cars and telecoms equipment. As a result, several chip-makers have raised prices.

Surging demand also results in producers increasing production capacity. It was recently reported that Taiwan Semiconductor Manufacturing is going to raise capital expenditures by 47% compared to the year before.

The risk is that supply eventually gets ahead of demand. This can be because demand starts to tail off or output capacity has expanded too much – often it is combination of the two. The result is excess capacity and low prices.

For the long-term investor, riding out the boom and bust cycles of the industry may be possible. However, investors should be wary of buying into the industry at the peak of its cycle if they aren’t prepared to hold during a bust period. But investors should also avoid trying to time cycles.

However, some argue that the industry is getting less cyclical due to the new structural drivers of demand. According to Dominik Poiger, ETF product manager and digital asset specialist at VanEck Vectors, many of the new uses of semiconductor chips are less prone to boom and busts. He says: “When you look at it from, for example, the perspective of artificial intelligence uses, there is heavy investment made regardless of economic state. So maybe we will see less cyclical outlook ahead.”

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.