Executive Summary

Debate has been heating up over recent weeks regarding the valuations of the leading global technology stocks and the risks they pose to market and portfolio returns. Views vary widely as to whether these stocks are overvalued but it is safe to say that as values continue to rise so too does the risk of a major price correction. Our approach to managing this risk exposure is to hold a portfolio of fund managers with differing strategies for investing in the technology sector.

Technology Sector Performance

When it comes to the technology sector, much of the focus is on the so-call FAANG stocks - Facebook, Apple, Amazon, Netflix and Google (now called Alphabet). According to recent research by Aitken Investment Management, these stocks have contributed 41% of the gain in the US stock market in 2017.

Globally, there are now sixteen listed tech companies with market a capitalisation over US$100 billion.

Investing in these companies has been very rewarding for investors and it is one of the key reasons that many Australian based investors have looked to international equity funds to gain exposure to this fast growing sector.

More recently, however, debate has heated up as to whether these stocks are now over-valued and the month of June saw a sharp pull-back in prices as investors became increasingly concerned about the risk of a market correction.

Given the dominance of the technology stocks, any investor, whether passive or active, needs to understand their exposure to this sector and the risk this poses to their portfolio should the sector suffer a major price correction. It is for this reason that we recommend holding a portfolio of international funds with different approaches to investing in the technology sector.

Fund Manager Strategies

International fund managers have adopted very different strategies when it comes to investing in the large global technology stocks. For the purposes of this article, we compare the strategies and performance of two of the highest profile international equity funds, Magellan Global and Platinum International, with four other managers that we have selected for the JJT Advisory model portfolio.

Weightings of major technology companies in international equity funds (Q2 2017)
(Source: Morningstar ARC, fund manager reports)

    
            Company
            MSCI World
            Magellan Global
            Platinum Int'l
            Fund A
            Fund B
            Fund C
            Fund D
        
            Apple
            2.2%
            7.6%
            
            Alphabet
            1.7%
						5.4%
						3.3%
						
						7.6%
						
            Microsoft
            1.4%
						4.5%
						0.3%
						1.6%
						2.4%
						
            Amazon
						1.1%
						
						2.7%
						
						5.3%
						
            Facebook
						1.0%
						3.8%
						
						1.8%
						
            Samsung
            
						3.0%
						1.2%
						2.6%
						
            Tencent
						
						2.7%
						
            Cisco
            0.4%
            
            1.9%
            
            2.5%
            
            1.0%
        
            Oracle
            0.4%
            3.8%
            1.6%
            
            eBay
            0.1%
            4.0%
            0.5%
            
            Baidu
            
            2.0%
            1.7%
            3.5%
            0.7%
            
            JD.com
            
            3.2%
            1.7%

As can be seen from the above table, the fund managers differ in terms of their level of exposure to the tech sector as well as their individual stock selections. In general terms, we view their stock selections across three investment segments:

High growth tech - these are the large, fast growing US tech stocks (otherwise know as FAANG) that trade on valuations that reflect continued rapid growth
Traditional tech - these are the longer established tech stocks such as Microsoft and Cisco that still benefit from the growth of the tech sector but which trade on more conservative valuations
Emerging tech - these are the fast growing stocks from China (Tencent, Baidu) and Korea (Samsung) that are now emerging as the next wave of companies that could rival their US peers

The different strategies adopted by the fund managers across these three sectors have contributed to large variations in fund performance over the last year and the performance over June in particular shows us which managers are most exposed to a major correction in tech stocks.

We now consider the factors that have driven the divergence in their performance.

Magellan Global FUnd

The Magellan Global Fund adopts a high conviction investment style with a strong bias towards technology stocks. While this strategy has served them well in previous years, it appears to have adversely impacted their performance over the last year. Magellan holds almost 30% of its portfolio in six tech stocks, most of which fall into the high growth segment. In the last year Magellan has underperformed the MSCI World Index by 0.4% and in the month of June has so far experienced a -1.8% drawdown vs -1.0% for the index.

The Magellan Global Fund provides investors with concentrated exposure to some of the world’s fastest growing technology companies but also presents a significant risk to portfolio returns should there be a major market correction in that sector.

Platinum International Fund

Platinum was one of our preferred fund managers one year ago and has performed strongly despite a relatively light exposure to the technology sector. Holdings in the major tech companies have ranged from 6-8% of the total portfolio and have been spread across the high growth, traditional and emerging segments.

While we still view Platinum as a sound option for international equities exposure, we have selected four other funds for our model portfolio going forward.

Fund A

Fund A is a contrarian style manager and adopts a similar approach to Platinum when it comes to investing in technology stocks, with an 8-9% allocation to four technology stocks across the high growth, traditional and emerging segments. The fund has been the strongest performer amongst the group year-to-date and has only experienced a small drawdown in June.

Fund B

Fund B has a 20% exposure to large technology stocks but has avoided the high growth segment altogether given their focus on selecting companies that they consider to be under-valued by the market. It holds five stocks across the traditional and emerging segments. The fund has performed strongly year-to-date and has experienced a better than benchmark drawdown in the month of June.

Fund C

Fund C uses a low turnover unconstrained approach to select companies in both developed and developing countries with resilient earnings and long-term growth potential. The fund outperformed the index in the 12 months to May 2017 and experience a draw-down marginally better than the index in June.

The fund maintained a below-benchmark allocation of 14.5% to the technology sector, but the two largest holdings in the fund were the FAANG stocks Amazon and Alphabet, totalling 11%.

Fund D

Fund D is a low volatility international equity fund which uses a highly quantitative process to select large-mid size companies in developed countries which have a low absolute risk. The fund has a low (7.5%) weighting to technology sector but almost no exposure to the large global tech stocks.

The fund underperformed the index by 0.5% in the 12 months to May 2017 but has avoided the losses generated by the index in June. This is consistent with its low-volatility mandate which seeks to preserve capital in the event of a market downturn.

Managing Risk Exposure

When it comes to selecting fund managers, our view is that you cannot rely on past performance and reputation alone but must also consider the manager’s ability to deliver superior risk-adjusted returns in the future. The risk of a major correction to the share prices of large tech companies is one example of a scenario we consider when evaluating fund manager strategies.

The analysis of the six fund managers above demonstrates that it is not necessary to have a large exposure to tech stocks in order to generate superior investment returns. It also demonstrates that investors in passive funds that track the index are more exposed than their active counterparts to a downturn in tech stock prices (with the exception of the Magellan Global Fund).

Our philosophy for investing in fund managers is similar to that of direct equities, combining diversification with conviction. We only select fund managers for our model portfolio when we have a compelling reason to do so based on a forward looking view of their strategy and their ability to meet the fund’s objectives. We then recommend these funds to clients, either individually or in combination, in accordance with our client's risk profile and the prevailing market conditions.

Disclaimer

This publication is issued by JJT Advisory Pty Ltd and is intended to be general information only without taking into account the investment needs, objectives and financial circumstances of any particular investor.

Past performance is not a reliable indicator of future performance.

Tech stocks: Managing investment risk