Kanchit Kirischhalar
While the current bull market is primarily driven by the AI boom and tech stocks, the iShares Expanded Tech-Software Sector ETF (BATS:IGV) may not be the right choice for investors looking for high returns. This is because the software industry has struggled to keep up with the robust revenue growth of other major categories in tech, resulting in declining investor confidence and weak performance. The outlook also suggests that software companies will likely struggle to sustain growth compared to semiconductor, communications and internet companies.
Slowing growth hurts software industry performance
IGV vs. S&P 500 Price Returns (Seeking Alpha)
After generating an astounding 58% price return in 2023, the iShares Expanded Tech-Software Sector ETF, which covers the software industry more broadly, has significantly underperformed compared to the broader market index, the information technology sector, and the growth category since the start of 2024. IGV’s share price gains are around 5% versus the S&P 500’s 16% gain, which is attributed to a slowing industry-wide revenue and profit growth trend. It appears that the phenomenal growth trend we’ve seen from software companies over the past few years has started to suddenly reverse.
Year-over-year revenue growth trends for the past three years (Seeking Alpha)
Software executives cited multiple factors for the slowdown in growth, including macroeconomic challenges, the end of COVID-related demand, and geopolitical issues. Salesforce (CRM), which missed revenue expectations for the first time since 2006 and issued a lower-than-expected revenue growth outlook, warned of shrinking deals and delays to new projects. Salesforce shares plummeted 20% after the release of its first-quarter earnings and have struggled to recover. CRM is a key component of the software industry and represents about 9% of IGV’s portfolio. Shares of Adobe (ADBE), the largest holding in IGV’s portfolio, have also fallen so far this year on concerns about future growth trends. Investor optimism for Intuit (INTU) also declined after the company announced adjusted EPS guidance of $1.80-$1.85 for the June quarter, below the consensus estimate of $1.92. Oracle (ORCL) also missed revenue and profit expectations for the March quarter. Dell Technologies (DELL) is also seeing its margins shrink and has lowered its full-year outlook.
While large software companies still seem well-positioned to rise to the challenge, the market environment has become tougher for small and mid-sized software companies. The stock prices of many small and mid-sized software companies have risen significantly over the past few years due to COVID-related demand and positive expectations. However, many of these companies are now underperforming. For example, SentinelOne (S) shares have fallen 26% so far in 2024 after the company sharply cut its guidance, and MongoDB (MDB) shares have plummeted 40% amid expectations of a 30% decline in full-year profits. Similarly, Paycom Software (PAYC) shares have fallen by more than half in the past 12 months. Zoom Video Communications (ZM) has also fallen 20% due to slowing growth.
Reasons for poor performance
A number of mid-, small- and large-cap software stocks have boomed in 2020 and 2022 as companies rushed to buy products for remote work. As COVID-related restrictions ended around the world, demand for software products and services has dropped significantly, which is clearly reflected in recent financial performance. Another reason for the industry’s downward trend is slowing economic growth. The Fed has kept interest rates at peak levels for the past two quarters, which has a direct impact on companies and economic growth. Although inflation has declined over the past few months, the Fed does not seem to be in a hurry to cut interest rates yet. Only one rate cut is expected in the second half of the year, compared to the initial forecast of three rate cuts. Therefore, US economic growth is likely to remain sluggish compared to past years. US GDP in the first quarter grew 1.4% compared to 3.4% in the previous quarter and is expected to remain sluggish throughout 2024.
Another risk factor for the software industry is the potential impact of artificial intelligence. Marc Andreessen, who said in 2011 that “software is eating the world,” now predicts that “AI is eating software.” While software companies have been using AI to enhance the performance of their products, the latest results and outlooks show that widespread adoption of AI is creating challenges for the industry. For example, with the help of AI, it becomes easier to obtain information, compile data, perform coding, create websites, and conduct medical research. In addition, AI is hurting software-as-a-service businesses, as companies such as Salesforce charge per user for their applications. On the other hand, AI can provide significantly higher efficiency, reducing the need for customer service representatives. Thus, the use of AI is increasing the risk of job losses, which could negatively impact software companies that use subscription revenue models.
Avoid IGV and consider other options
IGV Quantitative Rating (Seeking Alpha)
iShares Expanded Tech-Software Sector ETF tracks the performance of the North American software industry. The portfolio consists of around 120 stocks, with the top 10 stocks making up 60% of the portfolio. In addition to the large-cap positions, the portfolio also contains a number of small- and mid-cap software stocks, which have significantly underperformed due to negative growth. IGV has performed very well in 2023, with a price return of nearly 58%. However, it has significantly underperformed in 2024 due to the bleak outlook for the industry. Therefore, if you want to generate above-market returns in bullish market conditions, investing in a struggling industry may not be the right strategy.
Seeking Alpha Quantitative Ratings gives IGV a Hold rating due to weak stock price momentum, high expense ratios, and expanding risk factors. Technically, stocks and ETFs with declining momentum are deemed to underperform in the future. The ETF’s price performance also appears to remain under pressure based on fundamental factors such as earnings, competition, and economic trends. The AD+ rating on risk factors justifies my position that challenges for the software industry and related ETFs are likely to expand.
IGV Price Performance vs. Peers (Seeking Alpha)
There are many other investment vehicles that have the potential to outperform the market index. iShares Expanded Tech Sector ETF (IGM) is one of the best ETFs that investors can pursue for solid returns. This ETF has significantly outperformed the S&P 500 year-to-date and over the past 12 months. This ETF covers a broader set of technology stocks, with the information technology sector making up 80% of the portfolio and technology stocks in the communications sector making up ~20%. While IGM’s portfolio offers exposure to software stocks, its concentration in chip, hardware and technology stocks in the communications sector, such as Meta Platforms (META) and Alphabet (GOOG) (GOOGL), increases the potential for profits in a bull market.
Invesco NASDAQ 100 ETF (QQQM) is one of the attractive choices for investors to pursue in the current bull market, due to the portfolio’s diversification and concentration in the Big 7 Tech stocks and other large tech stocks. The ETF tracks the top 100 stocks listed on the NASDAQ. Its expense ratio of 0.15% is lower than IGV and IGM’s 0.41%, and its trading volume of $30 billion significantly outperforms its peers. Meanwhile, investors can also benefit from the robust performance of the growth category by tracking ETFs such as Schwab US Large Cap Growth ETF (SCHG) to earn high risk-adjusted returns. The portfolio’s concentration in the Big 7 Tech stocks, plus diversification into the healthcare, financial, and industrial sectors, can generate high risk-adjusted returns.
Conclusion
While the US stock market is expected to continue its bull run, with market indexes posting a second consecutive year of double-digit earnings growth driven by large tech stocks and the outlook for improved performance in the healthcare, financial and medical sectors, investing in a struggling and laggard ETF like IGV could mean missing out on capitalizing on the uptrend. High expense ratios, increasing risks and slowing momentum make it an unattractive option. Meanwhile, ETFs such as QQQM, SCHG and IGM could be solid alternative options.
