What’s Wrong with Current ETFs?

One of the problems with Cybersecurity ETFs is that most (except for IHACK) are market-cap weighted. This is bad because it assumes that the probability of financial success is higher for large cap compared to small cap cybersecurity firms. This is wrong for two reasons. The first reason is that the cybersecurity market is rising year over year so all firms are poised to grow profits. This isn’t just theory. We’ve seen similar percentage year-over-year revenue growth between small (e.g. SentinelOne) and large (e.g. CrowdStrike) cybersecurity firms! If growth is the same, why hold more of the larger firm in our portfolios/ETFs? The second reason is that these small firms do in fact have competitive advantages and aren’t just new entrants trying to make a quick buck by taking advantage of the rise in demand of cybersecurity (in response to the rise in significant attacks). I don’t doubt those companies exist, however it looks like the firms that pivot are more likely to fall into this category, and so we will label these as Tier 2 cybersecurity companies.

ETF Proposal

My proposal is to categorize companies into two tiers. Tier 1 and Tier 2. Tier 1 is pure-play cybersecurity companies or companies where cybersecurity revenue is the majority of the revenue mix. Tier 2 companies consist of firms that offer security but are not known or do not depend on that revenue. The rationale for Tier 2 is that it’s significantly more difficult to judge how important the cybersecurity segment is to these companies as well as being able to retrieve division financial stats on demand. In contrast, for pure-play firms, we can just go to Yahoo Finance. For Tier 2 companies, we’d have to read their 10K annual report. Sure an ETF provider can easily do this, but there’s an assumption that the cybersecurity division is a reported segment to begin with!

The tier 2 companies should have half the weight of the tier 1 companies. We could even argue that there should be a tier 3, however, that requires some more effort in differentiating and sorting.

Disclaimer: I own shares in CloudFlare.