Smartphones have proved to be a breakaway success in consumer electronics - not to mention a multibillion-dollar market opportunity. Not surprisingly, this has fueled runs in a number of stocks and significant investor interest in playing the ecosystem. Now, investors have an easier one-stop shop for this play with the introduction of First Trust's Smartphone Index Fund (Nasdaq:FONE). (For some background on the smartphone market, check out The Apple Ecosystem.)

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Smartphone ETF: How It's Built
FONE is an exchange-traded fund (ETF) that is designed to closely track the Nasdaq OMX CEA Smartphone Index. This index includes a variety of companies organized into three primary categories - handsets, software applications and hardware components, and network providers - with 45% weightings to the first two and 10% to the last. Within each segment, the components are equally weighted.

The Good
There is no question that FONE offers a diversified play on a broad definition of the smartphone market. All in all, the fund holds 73 positions with the top 10 positions amounting to about 28% of the total holdings. While the expense ratio is something of an issue, it is hard to see how a retail investor could assemble anything close to a diversified portfolio of similar component, service and equipment stocks and not spend more in commissions.

What's more, some investors may be surprised at how globally diversified this fund is as well - U.S.-based companies make up slightly less than 44% of the fund, while Asian companies comprise about one-third of the holdings. This could be a major positive for investors who want to be more internationally diversified, but either cannot or will not invest directly in overseas markets or the often-illiquid ADRs that trade over here. (For more, see Exchange-Traded Funds: Background.)

The Bad
There are some apparent drawbacks to this fund. For starters, the fund's 0.7% expense ratio is no particular bargain by ETF standards.

The make-up of the fund is also something of an issue; a sizable chunk is invested in assemblers and providers of electronics manufacturing services like Flextronics (Nasdaq:FLEX). As an industry, these companies have a rather iffy history of returns on capital, are not generally seen to have strong economic moats and tend to have rather cyclical growth patterns. Consequently, the nearly 20% weighting to this industry might be problematic for some investors.

Likewise, some investors may be unhappy with the apparently low weightings of heavy-hitters like Apple (Nasdaq:AAPL) and ARM Holdings (Nasdaq:ARMH). Going a step further, the presence of stocks like Verizon (NYSE:VZ), China Mobile (NYSE:CHL) and AT&T (NYSE:T) may be a weird counterbalance. Smartphones are a hot growth area in tech right now, and more aggressive tech-oriented investors may not find these slow-growing dividend-paying stocks to their liking. What's more, there is not enough weighting here to really turn this into one of those rare "income plus tech" opportunities. (For more, see 4 Steps To Building A Profitable Portfolio.)

The Weird
The rules governing how the index (and by extension, the fund) is set up lead to some strange outcomes. For example, few component companies seem to get as much smartphone-related press as Broadcom (Nasdaq:BRCM), and yet Broadcom is a smaller position in the fund than Atmel (Nasdaq:ATML). Likewise, much has been made of Google's (Nasdaq:GOOG) operating system, but Google represents less of the fund than ON Semiconductor (Nasdaq:ONNN).

Going a step further, it is interesting to see that Intel (Nasdaq: INTC), Microsoft (Nasdaq: MSFT) and Hewlett-Packard (NYSE:HPQ) are not listed in the holdings - a rather damning indictment of HP's purchase of Palm and the progress of Intel/Microsoft in penetrating this market.

The Bottom Line
For investors who would expect a smartphone ETF to be a retelling of Snow White and the Seven Dwarfs with Apple in the role of Snow White and chip stocks like Broadcom playing the role of "dwarf", FONE might be something of a surprise. On one hand, the fund may find criticism for being neither fish nor fowl, but others will see that as a strength and a selling point.

The smartphone ecosystem and market opportunity is bigger and broader than many people often believe. This fund makes a rather bold attempt to embrace and reflect that reality. Investors should be cautious about the heavy role of assemblers in this fund, but those looking for a broad play on components, software and services tied to the major growth consumer electronic market of current times might find this fits the bill nicely. (For more, see Sector-Based ETFs Spread Out Risk.)

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