Warren Buffett has long touted the virtues of investing in a low-cost index fund that tracks the S&P 500 index. The thinking behind this recommendation is that an S&P 500 index fund will track the broader market, delivering low-risk, average returns with low costs.
But there are also sector-specific exchange-traded funds (ETFs) that offer exposure to specific sectors. And while Buffett is more modest in picking specific sectors to win, it seems likely that the technology sector will, over the long run, outperform.
After all, technology is making its way into more and more of our daily lives, through smartphones, cloud computing, and now artificial intelligence. The sector, with its high technical and capital barriers, has also generally produced high margins in recent years.
Within the technology sector, one subsector has outperformed all others.
The semiconductor sector has trounced the market
Over the past 10 years, the overall S&P 500 has performed quite well, with an annualized return of 10.7%. That has been a really great decade, outperforming the market's long-term average.
A lot of those returns have been powered by technology companies. The QQQ Trust, an ETF that aims to mirror the Nasdaq 100 index, which in itself is a proxy for the technology sector, has vastly outperformed the broader market, with a 16.7% annualized return over the past decade.
But within technology, which subsector has performed even better? Semiconductors. Over the past 10 years, the semiconductor sector, as defined in the iShares Semiconductor ETF(NASDAQ: SOXX), has compounded at a stunning 20% annualized rate.
That level of compounding tops even the 19.9% rate at which Warren Buffett's conglomerate, Berkshire Hathaway, has compounded -- although Berkshire has impressively grown at that average rate over a whopping 60 years!
What kind of difference does a 20% rate make versus a 10.7% rate? At these levels, a mere $500 monthly contribution to the iShares Semiconductor ETF over 10 years would increase to an astounding $155,906 -- 2.6 times the amount of money contributed. That compares with just $98,941 if invested in the S&P 500 for a similar length of time.
Why the semiconductor sector has outperformed
Semiconductors have a reputation for being wildly cyclical, and that is somewhat true. However, more and more chips are going into our PCs, phones, household appliances, and cars every year. In conjunction with that, game-changing technologies, such as the internet, cloud computing, and, more recently, artificial intelligence, have created entirely new industries and pools of demand.
So, why so cyclical? Because semiconductors are hardware and, thus, prone to the "bullwhip" of booms and busts. The bullwhip effect happens when customers rush to buy in good times, only to freeze up and burn down their inventories when times get tough. But taking a long-term look over 10 years, the overall trend is clearly upward and to the right, with a higher rate of growth than gross domestic product (GDP), given the increasing density of semiconductors in all products and services over time.
The sector also has a reputation for being fiercely competitive. While that's somewhat true, a wave of consolidation among the big players in the industry over the past 20 years has often reduced competition to a few players in each industry subsegment. That has helped the sector increase margins relative to the past, leading to outsized profit growth.
Here are the iShares Semiconductor ETF's top 10 holdings:
Company
% of iShares Semiconductor ETF Assets
Broadcom
8.7%
Nvidia
7.9%
Texas Instruments
7.4%
Advanced Micro Devices
7.1%
Qualcomm
6.8%
KLA Corporation
4.5%
Applied Materials
4.3%
Monolithic Power Systems
4.3%
Lam Research
4.2%
NXP Semiconductors
3.9%
Can history repeat itself?
Some would say it would be a stretch for the iShares Semiconductor ETF to repeat last decade's performance in the upcoming decade. After all, 10 years ago, the cloud computing revolution was just gaining critical mass, and the artificial intelligence revolution, ushered in with the release of ChatGPT in 2022, hadn't happened yet.
However, it appears to be a pretty good bet that the iShares Semiconductor ETF will continue to outperform over the long term. As long as technological innovation continues apace, humans will continue to use technology to improve their lives, save time and money, and boost connectivity. That means more semiconductors. And as semiconductor-led innovation also creates entirely new markets (like AI), the semiconductor sector should continue to outgrow GDP.
Given the massive amount of capital and technological resources required to compete, I would also expect relatively stable competition and the preservation of margins. No doubt, there will be heated competition for AI supremacy in the years ahead. However, the beauty of owning an ETF is that it will capture the winners and lower its allocation to the losers over time.
Warren Buffett's late longtime partner, Charlie Munger, used to say that over the long term, a stock's return tends to mirror its return on invested capital (ROIC). Given the generally high ROIC of leading chip designers, manufacturers, and equipment companies today, it seems likely that the next decade will also be a positive one for semiconductor stocks, just as the last one was.
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Billy Duberstein has positions in Applied Materials, Berkshire Hathaway, Broadcom, KLA, Lam Research, and Texas Instruments. The Motley Fool has positions in and recommends Advanced Micro Devices, Applied Materials, Berkshire Hathaway, Lam Research, Nvidia, Qualcomm, Texas Instruments, and iShares Trust - iShares Semiconductor ETF. The Motley Fool recommends Broadcom, Monolithic Power Systems, and NXP Semiconductors. The Motley Fool has a disclosure policy.
