High Risk, High Reward: A Deep-Dive Analysis Of VanEck Semiconductor ETF (SMH)

Investment Thesis

The VanEck Semiconductor ETF (NASDAQ:SMH) has performed remarkably over the last five years. The fund’s low expense ratio and fees combined with close replication of what has been a massively lucrative industry has generated superb returns for shareholders.

However, an increasingly bearish macro combined with what I believe is a potential overvaluation with regards to the holdings present within the SMH ETF suggests outsized returns in the coming years may be difficult to find.

The limited diversification present in holdings suggests the fund is high-risk in nature and subject to significant volatility making it unsuitable in my opinion for most ETF investors.

While I still think the fund is a sound pick should you be seeking exposure to the semiconductor industry, I see excessive short-term risk and downside potential.

I therefore rate the VanEck Semiconductor ETF a Hold at present time.

TVC’s ETF Analysis Structure

The Value Corner’s professionally developed ETF Analysis Structure has been designed to provide an easy to interpret ranking system which can be utilized across any and all ETFs and index funds.

The tool ranks ETFs based on categories in which a fund can be awarded up to five stars. With regards to rankings, five represents a ‘good’ score with one representing a ‘poor’ score.

The “Total Rating” assigned to each firm is an aggregate of the number of stars earned in each category divided by the maximum possible score, multiplied by 100 and expressed as a percentage.

Fund Objective – ****

The SMH fund aims to closely track the performance of the MVIS U.S. Listed Semiconductor 25 Index (MVSMH). This index produced by MarketVector is in and of itself designed to track the aggregate performance of U.S. listed companies involved in the design, manufacture and sale of semiconductors and their related equipment.

The VanEck Semiconductor ETF accordingly has 25 holdings which are broadly speaking the 25 largest U.S. listed companies present in the semiconductor industry.

From the perspective of a potential investor, the objective of this fund is to offer a passively managed ETF with acute exposure to the semiconductor industry rather than to diversify across a number of sectors.

While the asset class structure is very narrow with only 25 holdings, sufficient breadth is present in my opinion to accurately represent the semiconductor industry while maintaining a focus on the largest and highest ‘quality’ companies within the sector.

Fundamentally, I believe that VanEck’s Semiconductor ETF’s core objective is well defined, providing investors with a transparent, clear and logically sound thesis.

However, given that the fund is so incredibly concentrated (by design) on the semiconductor industry, I do not believe its objective is suitable for a wide range of investors with the ETF instead being designed for a select audience.

This earns the fund’s objective a FOUR-STAR rating.

Asset Selection Process (ASP) – *****

The underlying MVSMH index being tracked by SMH is a modified market cap-weighted index. As a result, assets must meet certain criteria before being included in the MVSMH index and accordingly in the SMH fund.

Given that SMH simply replicates the MVSMH index, I will from now on be referring primarily to the ETF with the understanding that these ASP elements arise from the underlying index.

In order to be eligible for inclusion in the index, companies must produce 50% of revenues from semiconductor industry operations. Thereafter, 50 of the largest stocks by market capitalization are selected with a minimum market cap of $150M being required.

Thereafter, the index selects the 25 largest stocks as defined by free-float market capitalization and three-month trading volume which must exceed $1M.

The ASP processes present within the underlying index are sound in my opinion. Adherence to the fund’s objective of providing exposure to the largest companies in the semiconductor industry is achieved with select modifiers ensuring the entities present within the index are relevant.

VanEck’s SMH itself uses a passive indexing approach which simply aims to replicate the underlying MVSMH index rather than beat it. I view this positively as it provides investors greater transparency with regards to the fund’s ASP as it is simply the same as that of the index.

As a result of the ASP, SMH has 25 security holdings with an average market capitalization of $405.4B. The largest holding in the fund currently is Nvidia (NVDA) which represents 28% of net assets.

Market-cap weighted funds tend to heavily skew ETF exposure to a couple of the largest firms, especially if there is significant variance in market capitalizations among the securities held.

The VanEck Semiconductor ETF has what I believe is a massive variance in market-capitalizations (given the fund has just 25 holdings) with Universal Display Corporation (OLED), the smallest company in the index, having a market cap of just $7.73B while Nvidia’s is $2.24T.

As a result, SMH sees the Nvidia, TSMC (TSM), AMD (AMD), Broadcom (AVGO) and ASML (ASML) account for an outsized 53.8% of net assets with the remaining 20 holdings accounting for just 46.2%.

Overall, I believe the VanEck Semiconductor ETF has a high-quality ASP which accurately achieves the fund’s objectives and goals.

While the outsize exposure to a particularly massive stock such as Nvidia may increase volatility, it is undeniable that the fund’s asset selection process accurately tracks the index and the greater semiconductor market.

I therefore rate the fund as having a FIVE STAR ASP.

ETF Provider – ****

VanEck is to this day a privately controlled family business owned by the Van Eck family. Jan van Eck continues to head the firm as CEO with the firm retaining a business strategy similar to that of when it started over 65 years ago.

When compared to the likes of Vanguard or Blackrock (BLK), VanEck can be described as a specialist ETF provider. The firm has developed a stronghold in the market for niche-investments products which unlike hugely popular funds such as SPY or QQQ, aim to track much more acute indexes.

Indeed, funds such as SMH have become massively popular in themselves, with the seemingly endless growth in investor appetite for ETFs boosting many of VanEck’s products popularity.

I like VanEck’s focus on a niche marketplace and believe the family-run nature of the business increases the credibility of the firm.

Family-run enterprises tend to have a greater focus on maintaining excellent business fundamentals all the while avoiding the temptation to seek short-term gains at the expense of continued steady value accumulation.

Nevertheless, corporate structures that actively reward employees and shareholders through profit sharing and ownership schemes (such as Vanguard) continue to set the gold standard for provider quality, at least in my opinion.

Therefore, I rate VanEck as a FOUR-STAR provider.

Management Team – ****

VanEck’s SMH portfolio continues to be managed by Peter H. Liao who began managing the fund all the way back in late 2011. Liao himself is a CFA, having obtained a BA in Mathematics and Economics from NYU before being hired by VanEck in 2004.

With just under 20 years of experience within the organization and 13 years at the helm of the Semiconductor ETF, Liao has what I deem to be an excellent level of knowledge and ability to continue managing the fund efficiently.

Interestingly, February 2024 has seen a new development in the fund’s management team with Liao now being accompanied by Griffin Driscoll acting as deputy portfolio manager.

Driscoll appears to also be a highly experienced individual having obtained a Finance degree from Providence College as well as working at JPMorgan Chase as an ETF operations analyst before joining VanEck in 2018.

The move to appoint another manager to the fund could potentially signal either an internal organizational shift towards workload management or succession planning.

Regardless, I really like the great levels of experience present within the management structure of the fund and assign the management team a FOUR-STAR rating.

Expenses & Fees – ***

The SMH fund has a total annual fund operating expense of 0.35%. This means that for every $1000 of value invested into the fund, VanEck takes $3.50 as a management fee.

While this management fee is not quite as low as say the S&P500 tracking SPY’s gross expense ratio of 0.0945%, it is still very low compared to most other funds.

It is also worth considering just how small the expense ratio is in relation to the total AUM of the fund. SMH has just $19.15B in AUM while a fund like SPY has $506B.

Considering the more niche nature of the VanEck Semiconductor ETF and the relatively small overall size of the fund, I find the 0.35% expense ratio to be perfectly acceptable.

Seeking Alpha’s quant has accordingly provided a “B” expense grade for SMH which I believe is quite accurate given the 29% smaller expense ratio relative to all other ETFs.

Therefore, I give SMH’s Expenses & Fee’s structure a THREE-STAR rating.

Performance Metrics – *****

The last five years have seen SMH achieve truly remarkable levels of performance relative to broader market indexes. Huge 313% gains since April, 2019 make even the historically unprecedented 83% and 146% advances of the S&P500 and Nasdaq-100 respectively seem unimpressive.

The shortage plaguing manufacturers in the lead-up to 2020 drove prices higher for chips, with the sudden increased demand for laptops, smartphones and remote-working solutions induced by the COVID-10 pandemic adding further fuel to the metaphorical fire.

This demand spike was however short-lived with the SMH index contracting over 50% as a result of a widespread market selloff.

Nevertheless, the bull-run that started in late 2022 was further boosted by the start of an AI-hype train that has seen the ETF’s valuation surge 132% over a 15-month period.

Considering the truly unprecedented returns generated by the SMH fund over the last five years, I find it difficult to assign anything less than a FIVE STAR rating for the fund.

However, I would suggest significant caution be applied to extrapolating such returns into the future and personally believe a significant downturn may be around the corner for the fund.

Investment Style & Risk – *

Seeking Alpha’s quant assigns SMH a “D-” risk rating. I am largely inclined to agree with this assessment and believe the ETF is definitely a high-risk security.

Limited diversification both with regards to companies and industries may increase the cyclicality and amount of surprise present in returns from the fund.

Indeed, SMH has a beta ratio of 1.60x which illustrates just how volatile the ETF is compared to the broader market, along with an annualized volatility ratio of 27.7%.

I also see potential investors as gaining marked exposure to risks arising from the semiconductor industry itself. Fundamentally, demand for semiconductors is highly cyclical, being most commonly tied to the overall performance of the greater economy as a whole.

This means that during times of significant demand, earnings for companies in the industry are massive.

However, during times of recession or economic stagnation, many semiconductor companies may see falling revenues and declining margins. This is further amplified by the industry being massively capital intensive with manufacturing processes often revolving around massive economies of scale to ensure efficiency and profitability of the operations.

Considering the huge gains earned by semiconductor firms over the last year as a result of an AI driven bull run, it is very plausible that such a rate of investment into chips cannot be maintained indefinitely.

The massive bull-run also raises concerns with regards to the valuations of the underlying securities that constitute the holdings in the SMH fund. The top five companies have a mean TTM GAAP P/E ratio of 108.41x compared to 81.31x just five years ago.

Despite the significant growth that is being forecast for many of these key players, I find it difficult to believe the current rate of revenue and EPS growth as some of these firms can be sustained into the future.

Considering the lack of diversity present in this fund (despite it being by design), the cyclical returns generated by the semiconductor industry and the now quite pricey valuation of many of SMH’s key holdings, I believe the fund exposes investors to a very high level of risk.

I therefore assign SMH a ONE STAR rating for investment style and risk.

Summary & Total Rating

The VanEck Semiconductor ETF earned a total of 26/35 points in The Value Corner’s ETF analysis structure’s rating system.

This qualifies the fund for a light-green color coding, which falls 6% shy of the 80% mark required for an emerald color code but 4% above the 70% cutoff below which a chartreuse color coding is applicable.

Critical drawdowns in the fund’s total rating came from the significant volatility and risk present in the underlying holdings due to the cyclical characteristics of the semiconductor industry. Exposure to a limited set of assets further contributes to the risk present in this fund.

Buoying the fund’s total rating were its excellent ASP (considering the fund’s targeted objective), a solid management team and truly outstanding performance over the last five years.

However, I would like to caution against extrapolating such returns into the future and personally believe a downturn may be around the corner given the slowing macro conditions and already exhausted AI bull run.

Therefore, I rate SMH as a Hold at present time.