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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.

2 New ETFs Track Cybersecurity Growth

Summary Since November 2014, two tactical ETFs tracking cybersecurity have been issued. CIBR offers a reasonable expense ratio and a portfolio of companies that have performed well over the past 5 years. HACK is widely traded and offers a NAV of more than $1 billion, although that comes at a price. Businesses involved in strategies, equipment and software designed to protect data and data networks are in great demand, and will continue to be for the foreseeable future. Hardly a month goes by without the announcement of a data breach, either in the business environment or in government. The risk to data security is not limited to the U.S., either – it is a global concern. It was just a matter of time before someone offered a tactical ETF that focused on companies involved in cybersecurity 1 – the term used to refer to the particular data risks inherent to information systems. There are now two such ETFs: PureFunds ISE Cyber Security ETF (NYSEARCA: HACK ) First Trust NASDAQ CEA Cybersecurity ETF (NASDAQ: CIBR ) In the following, I examine these two funds, comparing and contrasting their investment approaches. I will also provide an estimate of their growth potential over the coming year. HACK HACK is the older of the two funds by about 7 months. Its holdings, based on the index provided by International Securities Exchange, LLC (ISE), is divided between two sectors: Infrastructure Providers and Service Providers . Infrastructure Providers are companies that develop hardware and software for cybersecurity; Service Providers are companies the business models for which is “defined by its role in providing” cybersecurity services. 2 All holdings in the fund must meet the following criteria: 3 Cybersecurity activities are a key driver of the business; Must not be listed on an exchange in a country that employs restrictions on foreign capital investment; Must have a minimum market capitalization of $100 million; Must be liquid; 4 Must be an operating company (not a pass-through security). Weighting of the holdings is determined on two levels: sector exposure is determined by the aggregate market capitalization of the holdings in each sector, and companies within a sector are weighted equally. 5 Rebalancing and reconstitution are semi-annual, in June and December. 6 Dividends are expected to be distributed monthly, while capital gains will be paid annually. 7 CIBR CIBR has been on the market for just over one month, as of this writing. Its index is based on the Consumer Electronics Association ‘s (CEA) cybersecurity classification, which requires that companies satisfy one of the following: 8 Focus on developing technologies designed to protect computer and communications networks from attack and outside unauthorized use; Involvement in deploying cybersecurity technologies to government, businesses, financial institutions and other industries; Focus on protecting priority data from unauthorized external access and exploitation. A company is eligible to be a holding of the fund if it: 9 Is classified as a cybersecurity company according to CEA requirements; Is listed on an index-eligible global stock exchange; Has a worldwide capitalization of at least $250 million; Has a three-month daily average trading volume of at least $1 million; Has a minimum free float of 20% of outstanding shares available for public trading. (In the case of companies issuing more than one security, only one holding is permitted.) Weighting is determined by the holdings’ liquidity; liquidity is determined using the three-month average daily dollar trading volume for each company. The portfolio is rebalanced quarterly, in March, June, September and December; the portfolio is reconstituted , if needed, in March and September. 10 Dividends , if any, are to be paid quarterly; capital gains will be distributed annually. 11 A Word About Dividends I would not expect either fund to pay any dividends on the basis of income received by way of dividends from their holdings. Very few of the companies in either fund’s portfolio pay dividends (fewer than one-third, in fact), and both funds use up the dividend income in covering expenses. Of course, dividends are only one source of income for an ETF, other mony coming through capital gains and interest. 12 The Holdings One would expect there to be a significant overlap in the holdings of these funds, given their tight focus; in fact, 23 companies are common to both portfolios – just over two-thirds of each. Both funds are open to holdings purchased in foreign markets, and each fund currently has six such funds, overlapping in three. Despite the fact that HACK and CIBR utilize different weighting strategies, there are six companies common to the funds’ top-ten holdings: Palo Alto Networks, Inc. (NYSE: PANW ); Cisco Systems, Inc. (NASDAQ: CSCO ); Fortinet, Inc. (NASDAQ: FTNT ); Proofpoint, Inc. (NASDAQ: PFPT ); Imperva, Inc. (NYSE: IMPV ); and Trend Micro Inc. ( OTCPK:TMICY ). Performance One should not expect much in the way of reliable performance information from new ETFs, particularly one that is less than two months old. However, the following chart shows the two funds to be dancing to the same tune, as it were: The performance of the two funds has to be taken in the context of what has been a fairly disappointing 2015 – in particular, very poor conditions have prevailed since mid-July. 13 A dismal summer has seen HACK drop from a high of $33.60 (June 23) to a close of $27.17 (August 21) – a drop of 19.14%. CIBR has pretty much seen only the downside of the market. Portfolio Performance Since a new ETF, by definition, has no extended history, when considering the potential it might have, I believe it helps to take a look at its portfolio and see how that collection of holdings has performed historically. 14 With this in mind, the following chart shows the performance of CIBR and HACK, starting from August 2, 2010: 15 (click to enlarge) Given the fact that the two portfolios overlap by about 66% of their holdings, it is no surprise that the two seem to march in lock step. However, by August 2012, CIBR begins to gradually outperform HACK, ultimately besting it by 2770bps. On an annual basis, CIBR has a CAGR of 20.75% compared to HACK’s 18.02%. There is no clear reason why the CIBR portfolio should so clearly beat HACK’s. The addition of two extra holdings should not be that much of a factor; both portfolios contain foreign equities; for sake of comparison, the standards set for CIBR’s portfolio seem marginally more stringent than the requirements established for HACK. If number of holdings is the difference, it shouldn’t be a factor to consider in choosing either fund. The indices the funds are based on are fluid in terms of content, and companies may either be added to or subtracted from the universe determined by their eligibility criteria. I should expect both indices to increase as security becomes a more pressing concern. Expectations Based on the five-year performance of their respective portfolios, the following chart shows one course these funds may track over the coming year: 16 (click to enlarge) Interestingly, the spreadsheet factored in a drop in value this month, and we are coming off one of the worse weeks the market has seen in quite a few years. In the long term, however, both funds are projected to do quite well, with CIBR expected to outperform HACK by a significant margin. 17 Assessment Both funds have a lot going for them. First Trust has a respectable history of offering responsible, quality, funds. PureFund ‘s HACK is simply huge – its NAV is currently ~ $1.36 billion , and trading volume has been significant. If there is any cautionary factor in HACK’s data, it would be its expense ratio; currently, its ER is listed at 0.75% – over the ~0.65% average for indexed funds, and well over the 0.60% ER for its competitor, CIBR. Given its NAV, an ER of that size is going to eat into income, leaving very little left for investors; not that CIBR is going to offer much in the way of dividends. Both funds are, and will continue to be, driven by developments in the cybersecurity market, and I do not see any reason to believe that market is going to drop off any time soon. If anything, as “cloud” storage becomes more and more prevalent one should expect to see increasing demand for continued research in, and development of, security solutions. The existence of an active – and persistent – hacking community will see to that. All in all, I perceive CIBR to be the better bet at this point, but the funds are too close to be able to say the choice is compelling. Disclaimers This article is for informational use only. It is not intended as a recommendation or inducement to purchase or sell any financial instrument issued by or pertaining to any company or fund mentioned or described herein. All data contained herein is accurate to the best of my ability to ascertain, and is drawn from each Company’s Prospectus, Statement of Additional Information, and fact sheets. All tables, charts and graphs are produced by me using data acquired from pertinent documents; historical price data from The Wall Street Journal . Data from any other sources (if used) is cited as such. All opinions contained herein are mine unless otherwise indicated. The opinions of others that may be included are identified as such and do not necessarily reflect my own views. Before investing, readers are reminded that they are responsible for performing their own due diligence; they are also reminded that it is possible to lose part or all of their invested money. Please invest carefully. 1 Cybersecurity , in the broad sense, refers to “products (hardware/software) and services designed to protect computer hardware, software, networks and data from unauthorized access, vulnerabilities, attacks and other security breaches.” (HACK Prospectus , p. 2) HACK’s documentation refers to “cyber security,” (dividing the term into two words) while other sources use the single word. I endeavor to use the single word throughout. 2 HACK Prospectus , p. 2. 3 HACK Prospectus , p. 2. 4 This is not clarified in the Prospectus, but it is assumed to mean that the holdings must each be actively traded on the market. 5 HACK Prospectus , p. 2. 6 HACK Prospectus , p. 2. 7 HACK Prospectus , p. 13. 8 CIBR Prospectus , pp. 1-2. 9 CIBR Prospectus , p. 16. 10 CIBR Prospectus , p. 2. 11 CIBR Prospectus , p. 11. 12 My estimations of prospective dividends for new ETFs has been fairly good, so far, any difference between my calculation and the actual payments made being in the investors’ favor. 13 As I write this (Friday, August 21, 2015), the Dow has just finished the day down more than 500 points (-3.12%). 14 There are limitations to such a “backtest,” of course: it would be onerous, if not impossible, to apply a fund’s eligibility/selection criteria to the past – unless one has a lot of time and computing power, not to mention extensive access to databases. (This is why issuers of index-based ETFs pay out substantial amounts to license the indices their funds are based on.) Since not all companies currently in a portfolio have been in existence for extended period, matters of re-adjusting weightings becomes a substantial nuisance – except in the case of equal weighting. 15 Each portfolio was primed with a $25K “investment.” Each holding within the portfolio is weighted the same, throughout the trial, as it is currently weighted; in the case of companies entering the market later than August 2, the allocation they would have received is held in reserve until their entry into the portfolio. Portfolios were rebalanced and reconstituted quarterly. 16 The projection is based on the “forecast” function in Microsoft’s Excel which apparently bases its projections on an exponential trend line extrapolated from historical performance. 17 Note: these forecasts are generated by a spreadsheet, and are based on the historical performance of each fund’s portfolio holdings. This is not intended to reflect my own expectations of either fund. For my part – and as any responsible investor should realize – one cannot predict the future performance of any stock simply on the basis of past performance. At least, not with any degree of accuracy. The chart should be taken to reflect a potential tendency for future performance. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.