Should I Choose Active or Passive for Tech Exposure?

Should investors seeking to add technology exposure to their portfolios therefore invest via a passive instrument that tracks a technology benchmark? 

Samuel Meakin 5 August, 2015 | 3:30PM
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Technology stocks have outperformed global stock markets over one, three, five and 10 years, beating both the MSCI World and the MSCI ACWI indices across each of those time periods.

But the average fund in the Morningstar Sector Equity Technology category has underperformed the MSCI ACWI Information Technology index over one, three, five and ten years, making manager selection particularly important for fund investors in the technology sector.

Active vs Passive for Tech Exposure

Should investors seeking to add technology exposure to their portfolios therefore invest via a passive instrument that tracks a technology benchmark? The popularity of technology as a theme has benefitted ETF providers with passive offerings in the sector. In 2014, despite overall outflows from active technology funds, technology ETFs saw net inflows over the course of the year.

Additionally, the lack of new funds in the actively managed segment of the technology sector is testament to the make-up of the existing fund universe, with most active money being managed by a relatively small number of established teams.

The route an investor should take into the technology sector of course depends on the investor’s specific objectives, as well as their attitude towards risk and their investment view of Apple (AAPL). A vehicle tracking the MSCI ACWI Information Technology index would have an allocation to Apple of more than 13% and in some indices the company’s weighting is even higher.

Clearly this is a significant absolute level of exposure, and something an investor looking for technology equities exposure should take into account when deciding the type of vehicle they should invest in. Investors should therefore ask themselves whether they are seeking purely to capture the index’s returns regardless of the inherent absolute stock-specific risk, or if they are more comfortable with a broader, more diversified exposure to the sector, albeit inclusive of the element of active risk that investment via an active manager introduces.

Many active technology fund managers highlight smaller companies as an area of focus from which they anticipate strong growth, stemming from such companies’ disruptive new technologies. As such, these managers typically seek to identify the sector’s future winners, avoiding, at least to a certain extent, the incumbent larger names whose technologies are arguably becoming increasingly obsolete. This approach is not without its own risks and is another factor for an investor to consider.

Indeed, this higher-growth focus caused relative performance to suffer at a number of funds in 2014, when the average fund in the Morningstar Sector Equity Technology category underperformed the MSCI ACWI Information Technology index by around eight percentage points. The more growth-focused stocks underperformed in a market rotation away from growth, despite many of them reporting solid results, whilst the larger tech incumbents tended to outperform amidst a wider market environment that valued the perceived safety of income. Valuations also had their part to play, given that many of the smaller growth names came into 2014 with quite full valuations whilst several of the large-cap technology stocks were trading at a discount to the market at the start of the year.

Some active fund managers in the sector place greater emphasis on the larger end of the market, employing a more benchmark-aware approach. These managers contend that it can be difficult to judge which of the companies involved at the early stages of a new technology will eventually go on to be successful and dominate their area of the industry. The larger companies with strong balance sheets are also able to share in the growth of new and emerging themes within the sector by acquiring smaller companies that are on the cutting edge of the relevant new technologies.

Another contributor to technology funds’ underperformance relative to the benchmark in 2014 was the strong performance of Apple versus the technology sector and the wider market; this affected the more benchmark-aware funds as well as those focused on the smaller-cap, higher-growth end. Apple’s significant weighting in the index will always present active fund managers with a headache, given that they are restricted to a maximum 10% absolute position size in the stock due to the UCITS constraints. A fund’s structural underweight to the company, therefore, will give rise to performance swings relative to the benchmark whether the shares outperform or underperform the wider market. The firm’s relative performance also causes a second-order attribution effect.

Which Active Funds Deliver?

Despite their longer-term underperformance as a whole relative to the benchmark, we continue to believe that there is a place for active managers within the technology sector, but clearly manager selection is of vital importance.

There are a handful of strong funds available to UK-based investors, and we point to four that are rated by the manager research team at Morningstar, namely Polar Capital Global Technology, Henderson Horizon Global Technology, GLG Technology Equity and GAM Star Technology. These funds have enjoyed strong returns over ten years or since their current managers took the helm. However, their performance profiles have differed significantly over the shorter term and investors have experienced varying levels of volatility.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Apple Inc189.87 USD0.02Rating
GAM Star Disruptive Gr USD Acc45.42 USD-0.03Rating
Janus Henderson Hrzn GlbTechLdrs A2USD203.70 USD-0.64Rating
Polar Capital Global Tech Inc110.60 USD-0.22Rating

About Author

Samuel Meakin  is a fund analyst for Morningstar

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