Semiconductor ETFs Under Scrutiny: SOXX and SOXS Face Challenges

SOXX: Inefficient Fund With Tracking Error

Investors may find better opportunities in other ETFs with lower costs and more efficient tracking for long-term growth and sector exposure. Investment Thesis The iShares Semiconductor ETF (NASDAQ:SOXX) is designed to track the performance of the semiconductor sector. It provides a granular view of the semiconductor market and aims to replicate the investment results of the ICE Semiconductor Index. The ETF has total net assets of over $16 billion and includes 30 holdings, with major names like Broadcom (AVGO), Nvidia (NVDA), and Advanced Micro Devices (AMD) comprising significant portions of the portfolio. SOXX's year-to-date (YTD) return of 26.63% appears impressive compared to the S&P 500's YTD performance of 17.32%. Despite the growing trend towards low-cost passive fund ETFs, the ETF has underperformed relative to its benchmark (NYSE Semiconductor Index) over past periods including YTD (the index is up 31.23% YTD). Over the last year, the ETF clocked in a 37.51% increase, which, although impressive in absolute terms, also slightly lagged behind the benchmark return of 37.56%. I've also noticed that SOXX's expense ratio of 0.35% is slightly higher compared to other passive funds, which typically have lower fees. This cost structure can eat into returns over time and drag the ETF relative to the benchmark. The fund's standard deviation, which stands at 27.63%, indicates high volatility, which is not suitable for many investors. Given these performance challenges, I think that there are better ways to gain exposure to the semiconductor sector for most investors. I believe Investors might want to consider alternative ETFs that offer similar exposure with lower fees and have better alignment with sector performance. Funds that combine a broader range of semiconductor companies, including those from emerging markets, I believe, could provide a more balanced and diversified approach. Considering the ongoing underperformance and the relatively high expense ratio, SOXX appears less attractive for capitalizing on the growth in the semiconductor sector. With this, (and the high standard deviation and tracking error which I dive into later) I think the ETF is a sell. In order to account for the tracking error, the ETF should probably trade at a slight discount to NAV to account for the tracking error. This will dampen investor performance. Background SOXX's structure is designed for those looking to gain exposure in the semiconductor sector without the need to pick individual stocks. The fund offers investors exposure to companies that design, manufacture, and distribute semiconductors with holdings concentrated in major semiconductor companies such as Broadcom (9.36%), NVIDIA Corp. (8.47%), Advanced Micro Devices Inc. (7.95%), and Applied Materials Inc. (6.48%). These firms are market leaders in the development and production of semiconductor technologies used in the advancement of AI, digital transformation, and other technology-driven innovations. Many of these names are solid, I am not doubting that. Since the fund aims to replicate the price and yield performance of US-listed semiconductor stocks, it offers investors with a concentrated exposure to this high-growth industry by benchmarking against the NYSE Semiconductor Index. SOXX is structured to invest at least 80% of its assets in the component securities of its index to ensure it closely tracks the performance of the semiconductor sector. The remaining 20% can be allocated to futures, options, swap contracts, cash, and cash equivalents to help further necessitate the goal of tracking this index. The goal of this allocation strategy is to help manage the fund's liquidity and risk while maintaining its investment focus. While SOXX provides a diversified exposure within the semiconductor sector, I will say the ETF for a thematic ETF does a decent job minimizing single-stock risk while capturing the overall growth potential of the industry. With 35 holdings as of July 16th, the ETF appeals to investors seeking cost-effective investment options with potential income. Tracking Error Is An Issue Unfortunately, I believe tracking error is a central issue for investors in SOXX, which reflects a disparity between the ETF's performance and that of its benchmark. The tracking error, or the standard deviation between the difference between the ETF's returns and its benchmark index, can lead to inconsistent performance relative to the benchmark. This inconsistency introduces an additional layer of risk for investors, potentially eroding the benefits expected from the ETF (following a diversified basket of semiconductor stocks). I believe the risk associated with tracking error is especially evident in volatile sectors such as semis. The industry is known for its rapid tech advancements and market fluctuations. During periods of high volatility, the costs associated with rebalancing the fund's portfolio to match the index can increase, which can exacerbate the tracking error. This was evident in the historical prices of SOXX, which have shown fluctuations over the past year. This tracking error issue arises from several factors which plague most funds (whether passive or active): management fees, transaction costs, and the liquidity of the underlying securities. For instance, while SOXX replicates the performance of its benchmark index closely, variations due to fees and expenses can lead to deviations. Although these deviations are often small, they can accumulate and impact long-term returns. Everything compounds in a fund, including the errors that are made While most of the fund's major holdings are in blue-chip stocks (like I mentioned above), the liquidity of these stocks can vary, especially during market stress, which can affect the ETF's ability to track its index accurately. The index's need to buy or sell large quantities of these stocks to adjust the fund's holdings likely leads to market impact costs, and contributes as well to the tracking error. Most ETFs have this issue to one degree or another. It's the magnitude of this issue here that is an issue. One of the primary contributors to tracking error is the inherent nature of index replication. While the core index, which SOXX aims to track, represents an idealized set of holdings, real-world ETFs must manage transaction costs, liquidity issues, and other frictions that do not affect the theoretical index. These practical challenges mean that SOXX cannot perfectly mirror the index's performance, leading to deviations that constitute tracking error. Tracking errors also introduce uncertainty in portfolio performance. Investors rely on ETFs like SOXX to provide specific market exposure - in this case, the semiconductor sector. However, high tracking error means that the ETF's returns will almost definitely not reliably represent the sector's performance, which can make it harder for investors to achieve their strategic objectives. This is particularly concerning for long-term investors who depend on consistent, predictable performance to meet their financial goals. While 35 holdings is more diversified than some other Semiconductor ETFs, a good ETF is even more diversified than this to uphold their principal as a way to make a diversified bet on an industry or belief. With this, I believe that there are better ETFs that offer lower tracking errors, which need to be considered for investors regardless of whether these ETFs are in the exact same space. Valuation SOXX demonstrates a poor tracking error, ranking a D according to the Seeking Alpha rating system over the past year, which indicates a deviation of 13.90% from the index it aims to replicate. This is further highlighted over longer periods, with a 21.73% tracking error over three years and 17.66% over five years. It signals volatility and deviation from the expected performance relative to the benchmark index, which is an issue for investors who prefer precise index replication. In the semiconductor sector, although certain companies show strong fundamentals, I believe the industry is likely on the verge of a correction. The bullish momentum seen in stocks like NVIDIA has raised valuations to unsustainable levels in my opinion in many cases. SOXX will also face downward pressure if market expectations recalibrate. This overvaluation is stressed by the high annualized volatility of 27.36%, significantly higher than the median for all ETFs, which indicates a sector susceptible to rapid and severe price swings. Given this backdrop, I believe adjusting the ETF's market price to trade at a discount to its net asset value (NAV) must be considered. A discount of around 5% would significantly cushion the ETF against its tracking error over the long run. This adjustment would lower the standard deviation relative to the index, and aligns with the ETF's price more closely with the actual value of its holdings. Trading below NAV would provide a buffer and reduce the impact of volatility and tracking error, and present a more stable investment vehicle during periods of sector correction. The ETF's quant rating remains a strong buy at 4.85. However, the persistent D- rating in risk metrics casts doubt- and I think there is a risk of a quant downgrade soon given these underlying risks, which rate poorly. Bull Thesis Despite my views, SOXX's tracking error over the past 12 months at 13.90% while still high, suggests that the ETF is aligning more closely with the benchmark index compared to longer horizon tracking error comparisons. To this point, I believe that SOXX's diversification within the semiconductor sector presents a mixed bag. With a C- rating for the concentration of assets in their top ten holdings, the ETF is somewhat more diversified than some of their more concentrated peers. However, this diversification is crucial in the highly volatile semiconductor industry, as it can mitigate the impact of underperformance by any single company. A top weighting near 10%, regardless, makes this an issue. It still indicates a relatively high concentration compared to broader market ETFs, which could expose investors to sector-specific risks. While some bulls of the semiconductor industry may argue that buying any diversified instrument with exposure to the space will offer some upside, I really believe it's imperative to pick which ones you side with. As an investor, rallies do not last forever, so this means when you're in a fund that is riding a strong underlying trend, it's crucial to extract every last bit of value out of the sector run up so you can help preserve your long run compounding rate. Due to the tracking error here, however, this seems much less likely. Takeaway Despite its attractive exposure to high-growth semiconductor companies, SOXX faces issues for investors seeking reliable index tracking. This lies in the tracking error, which reflects discrepancies between the ETF's performance and its benchmark. I further believe that this ETF (exacerbated by the high volatility of the semiconductor sector), could lead to highly inconsistent returns and drag to investors. As market volatility increases, the tracking error could further widen, and undermine the ETF's capability to replicate the index. Given the ongoing underperformance, high expense ratio, and significant tracking error, SOXX appears less suitable for capturing the growth in the semiconductor sector than what appears at first signed.. Investors will likely find better opportunities in other ETFs that provide more efficient tracking and lower costs, making them more reliable for long-term growth and sector exposure. Given the current market conditions and fund performance, I believe a sell for SOXX is warranted. This account is managed by Noah's Arc Capital Management. Our goal is provide Wall Street level insights to main street investors. Our research focus is mainly on 20th century stocks (old economy) undergoing a 21st century transformation, but occasionally we'll write on companies that help transform 20th century firms as well. We look for innovations in a business model that will cause a stock to change dramatically. Associated with SA contributors Thomas Potter and Elijah Buell. Analyst's Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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. Noah Cox (account author) is the managing partner of Noah's Arc Capital Management. His views in this article are not necessarily reflective of the firms. Nothing contained in this note is intended as investment advice. It is solely for informational purposes. Invest at your own risk. Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

SOXS: Pullback Or Bubble? Doesn't Matter, Continue To Avoid This Amortizing Trap

Even if this is the bursting of the AI semiconductor bubble, traders should be wary of holding the SOXS for too long due to extreme volatility decay. In a recent article, on the 1x Short VIX Futures ETF (BATS:SVIX), I noted investors should be cautious heading into the November elections, as rising political uncertainty could act as a headwind for stocks. In particular, as former President Trump's election odds rise, stock markets will increasingly have to start pricing in the former President's economic policies and may swoon or swell on his comments (Figure 1). It did not take long for my worries to become reality, as the former President's comments in a Bloomberg Businessweek interview on whether the United States should pay for Taiwan's defense caused Taiwan Semiconductor Manufacturing's (TSM) shares to plunge by more than 8% and helped boost the Direxion Daily Semiconductor Bear 3X Shares ETF (NYSEARCA:SOXS) to a 21% gain (Figure 2). SOXF ETF Overview How could the SOXS ETF gain an incredible 21% in a single day? The SOXS ETF achieves these incredible one-day returns via leverage from holding total return swaps against large investment banks like Goldman Sachs (Figure 3). SOXS and its companion fund, the Direxion Daily Semiconductor Bull 3X Shares ETF (SOXL), are speculators' favorites due to their ability to generate incredible one-day returns. The SOXS ETF has $794 million in assets and charges a 1.03% net expense ratio. Semiconductor Stocks Were Priced To Perfection In a sector where the ten largest stocks trade at an average Fwd P/E of 44.3x and an average Price/Sales of 12.9x, it is not a stretch to say the semiconductor sector was 'priced to perfection' (Figure 4). However, when stocks are so richly valued, a seemingly innocuous comment by the former President, coupled with rumors that President Biden is looking to tighten export restrictions further, can spark a dramatic selloff like the one we saw on July 17th (Figure 5). Pullback or Popping Of The AI-Bubble? For semiconductor investors, the key question going forward is whether this move in semiconductor stocks is merely a pullback after a fantastic rally or the beginning of something more ominous. In my opinion, the current hype surrounding semiconductor stocks like NVIDIA (NVDA) and Broadcom (AVGO) has all the hallmarks of an equity bubble, as investors seemingly cannot get enough of companies leveraged to the artificial intelligence ("AI") theme. For example, as I noted in Figure 4 above, the 10 largest semiconductor companies trade at an average P/S multiple of 12.9x, with NVDA trading at an absurd 39x. These are very high valuation multiples, consistent with equity 'bubbles'. Quoting Scott McNealy, the former CEO of Sun Microsystems ("SUNW"), a darling of the dot-com bubble: At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don't need any transparency. You don't need any footnotes. What were you thinking? Unfortunately, recognizing a bubble and being able to profit from the bursting of the said bubble are two completely different skills. For example, I have been wary about NVDA's shares since late 2023, and the stock has more than doubled since my warning. In my opinion, instead of trying to 'time' the popping of the AI bubble, prudent investors should avoid the sector altogether and look for investment opportunities elsewhere if they are not comfortable with the valuations. Even Bears Should Avoid the SOXS However, there will always be speculators who want to participate in the eventual popping of the AI bubble. Unfortunately, even for speculators who wish to play the downside in semiconductor stocks, I do not believe the SOXS ETF is a good choice. This is because the SOXS ETF suffers from extremely large tracking errors due to 'volatility decay'. 'Volatility decay' is best explained via an example. Assume we invested $100 in the SOXS ETF. If the underlying index loses 5% on day 1, the position will grow to $115 (3 times 5% return). However, if the index rises by 5% on day 2, the position will fall to $97.75 (3 times -5% return), significantly less than three times the 2-day compounded loss of 0.25% or $99.25. This tracking error is commonly called 'volatility decay'. While the one-day volatility decay may appear small in magnitude, when compounded over long periods, the loss from volatility decay can be very significant. For example, according to Direxion's modeling, even if the underlying semiconductor index declines by 60% over 1 year (a major crash), the actual realized returns in the SOXS could be significantly different (Figure 6). If volatility is high enough, the SOXS may deliver negative returns even as the underlying index declines. This is exactly what happened during the early days of the COVID-19 pandemic. From January to April 2020, the iShares Semiconductor ETF (SOXX), an ETF based on the same index as the SOXS, declined by 8%. However, due to the extremely volatile market environment, the SOXS ETF lost 52.6% during this period (Figure 7). Investors looking at the SOXS ETF should make sure they fully understand the tracking error risks involved with levered ETFs by consulting these FINRA and SEC warnings. Conclusion The SOXS ETF delivered an outstanding 21% return on July 17th, as semiconductor stocks declined across the board due to fears of a further tightening in export controls and comments from former President Trump regarding Taiwan. While declines in semiconductor stocks may yet continue, as the sector appears to be in a bubble and stocks are grossly overvalued, I would not recommend the SOXS ETF as a buy due to the volatility decay embedded in the product. Unless one has perfect market timing abilities, holding the SOXS is a one-way ticket to losses, as the fund has declined from a split-adjusted $98 million per share since inception in 2010 to $22.75 most recently (Figure 8). I continue to rate the SOXS ETF as an avoid (or sell). Author of the Macro Trends & Inflection Points Newsletter. I spent 5 years as a co-founder and hedge fund CIO / manager. Before that, I was a hedge fund analyst/portfolio manager at a leading Canadian alternative asset manager. I write articles as part of my own due diligence on the stocks that I find interesting.Follow my twitter or substack for my thoughts on the macro trends. Analyst's Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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. Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.