Technology funds for the long term

There’s a lot of nervousness around the valuation of global technology companies. Jeremy Grantham, co-founder and chief investment strategist of Boston-based asset management group GMO, has been sounding alarm bells for months. At the start of the year, he declared the US stock market to be in a ‘fully fledged epic bubble’. The big-tech-dominated S&P 500 index has risen by 18 per cent for the year to 24 September. 

It’s true that technology stocks are expensive on a historic basis. The tech-heavy Nasdaq Composite index currently has a 12-month forward price/earnings ratio of 31 times, according to FactSet. That compares with under 20 times five years ago. However, given the earnings boost many tech companies have enjoyed over the past 12 months, some analysts argue that many names deserve their high ratings. 

The worry is that extreme monetary policy, which has led to record low interest rates and a 25 per cent increase in the US money supply last year, has pushed too much money into high-growth tech stocks owing to paltry returns elsewhere. When monetary policy begins to tighten, these stocks could suffer as returns on bonds become more attractive and improved economic conditions help cyclical stocks.  

Inflation expectations are important for the valuation of tech stocks, but so far central banks have stuck with the narrative that inflation will be transitory and bond markets have appeared to have agreed. Ben Rogoff, manager of Polar Capital Technology Trust (PCT), says he sees many multi-year drivers that should be able to offset anything more than transitory inflation such as using software to automate business processes. He also notes that stretched valuations are largely market-related, reflecting the rerating of equities (and assets more generally) rather than technology stocks. "The relative price/earnings ratio of US tech is 1.2x the market which remains within the 0.9 to 1.3x range that has existed since the global financial crisis," he says.   

Walter Price, manager of Allianz Technology Trust (ATT), adds that a decrease in global birth rates and a pending labour shortage will force companies to invest in technology to boost productivity. He says we are in a period of rapid change, where solutions such as cloud, software-as-a-service, artificial intelligence and cyber security are key to the prosperity of most industries.  

While there is undoubtedly a lot of hype in some areas of technology, Darius McDermott, managing director of broker Chelsea Financial Services, says he believes there is "a misconception that tech is expensive”, particularly when it comes to mega-cap companies. He thinks that share price rises in companies such as Facebook (US:FB) and Alphabet (US:GOOGL) have been “fully backed up by exceptional earnings growth”.

He says that Alphabet is constantly reinvesting huge amounts of money into new projects and that while Google Cloud is currently lossmaking, it suppresses the parent company’s profits but is “very likely to become a very profitable business in its own right in the future”. Facebook, meanwhile, has fallen out of favour among many following a series of scandals – most notably regarding Cambridge Analytica. However, it has a very strong balance sheet and projects such as Oculus are making it a world leader in virtual reality. And if it is allowed to launch its stable coin, Diem, this could bring financial services to millions or even billions of people.

Regulation has always been a potential risk for technology investors, with recent events in China proving just how damaging this can be, as Dave Baxter discussed in last week’s cover story, The China Dilemma. Alibaba’s (HK:9988) share price has halved since its peak last October, before the IPO of Ant Group was pulled and the sprawling conglomerate was faced with a $2.8bn antitrust fine. Similarly, Tencent’s (HK:0700) share price has fallen over 40 per cent from its peak in February this year, following a $1.5bn fine and tougher regulations in China’s gaming industry.

How big tech is fighting off challenges  

In the West, there is an increasing appetite for the big tech titans to pay more in tax. It is also possible that they could be forced to split up by competition lawmakers, although McDermott thinks that many of the tech companies wouldn’t be hurt by this as they are “probably worth more than the sum of their parts anyway”. 

Blockchain technology may also present a real threat for those who don't adapt. Decentralised versions of Twitter, Facebook and YouTube, which operate as a decentralised autonomous organisation and incentivise their users to use the platform by sharing revenue with them, could be a potential threat in the near future. Of course, the tech companies are very aware of this and are already preparing and building, hence Facebook’s development of Diem and Twitter’s decision to roll out bitcoin tipping. 

The big risk associated with investing in highly rated, lossmaking technology companies is the possibility of persistent high inflation levels and a rise in bond yields. However, McDermott thinks the profitable megacap tech companies might handle inflation better than most. “It's not as if [when] the price of copper doubles it will hurt their profits and wages are already very high in the tech sector so whilst there will always be some wage pressure we think they will manage it,” he says. 

Funds for technology exposure

While not as pronounced as some market commentators might have expected, there has been a shift in investor sentiment over the past year to cyclical stocks more likely to benefit from an economic recovery. This has led to cheaper valuations in tech-focused investment trusts, which are now trading on significantly wider than average discounts that could present an attractive buying opportunity. 

Polar Capital Technology Trust, for example, was trading on a discount to net assets of 9.3 per cent on 27 September (according to brokerage Winterflood) following several months of trading at a premium last year. Investment manager Rogoff aims to construct a portfolio of around 100 stocks by selecting companies that he believes will be able to generate returns 30 to 50 per cent higher than the average company in its benchmark index, the Dow Jones Global Technology Index. 

The trust is also managed with an active eye on risk. It is designed to consistently deliver 3 per cent annual outperformance versus the benchmark after fees, with a typical active share of 40 to 50 per cent. It rarely makes outsized stock level bets, but instead focuses on trying to identify the most important secular themes and avoid investing in losers (often mature, or blue-sky companies, in Rogoff’s opinion). Rogoff sees value in the more cyclical areas of tech currently, citing chipmaker Micron Technology (US:MU) and data storage company Seagate (US:STX) as "two cheap names that should do well in the event of upside risk to global growth and/or higher risk-free rates".

Allianz Technology Trust is a higher-conviction option, with its shares also trading at a wider-than-average discount of 8.1 per cent on 27 September. The trust made large gains last year by taking chunky positions in fast-growing companies such as Zoom Technology (US:ZNTO) and Tesla (US:TSLA). However, this year, Price has also repositioned the trust to have a higher weighting on what he views as more value-oriented technology stocks such as semiconductor manufacturers, hardware companies and ‘growth at a reasonable price’ companies such as Alphabet and Microsoft (US:MSFT) – the fund's two largest holdings at the end of August.

In a recent fund update, Price said that having pulled back a little this year, technology stocks in aggregate are now at a 10 to 20 per cent premium relative to the rest of the market but he thinks this is justified given the ‘golden age’ of technology that we are entering. Cloud security company Zscaler (US:ZS) has been one of the trust’s top relative contributors in recent months, a first-mover in the nascent and high-growth cloud security arena. Over a five-year period, once the economic recovery following Covid-19 has played out, Price thinks more investors will return to technology for growth. 

Neither of the trusts have particularly large exposure to China, although Polar Capital Technology has 11.2 per cent in Asia ex Japan while Allianz Technology has under 3 per cent invested in Asia. This has boosted the relative performance of the Allianz fund, which has had a net asset value (NAV) increase of 38 per cent for the year to 24 September, compared with 29 per cent for Polar Capital Technology.

If you want to invest in a technology fund, check it doesn’t have too much overlap with funds you already own. Baillie Gifford, for example, which looks to identify exponential growth firms with strong competitive advantages, has a high weighting to tech-enabled companies in the majority of its funds. Baillie Gifford US Growth Trust (USA), for example, which was trading at a discount of 2.8 per cent on 27 September, counts Shopify (US:SHOP), Amazon (US:AMZN) and Tesla (US:TSLA) in its top 5 holdings, all of which were held by Allianz Technology at the time of its interim report at the end of June. 

Specialist technology exchange traded funds (ETFs) can give you more targeted exposure to tech themes, as we pointed out in “Playing future trends with niche ETFs”, ETFs such as iShares Automation & Robotics UCITS ETF (RBTX), WisdomTree Cloud Computing UCITS ETF (KLWD) and iShares Digitalisation UCITS ETF (DGIT) can give you access to the types of themes favoured by Rogoff and Price but at a much lower price, as all three of these products have an ongoing charge of 0.4 per cent. 

Polar Capital Technology and Allianz Technology both have management charges of around 0.8 per cent with performance fees payable on top of that if the trusts outperform their benchmarks. The tech-heavy Scottish Mortgage Investment Trust (SMT) has one of the lowest fees among active funds, at 0.34 per cent. Scottish Mortgage’s NAV is up 20 per cent over the past six months, despite its significant weighting to Chinese companies, counting Tencent, Nio, Meituan (US:MPNGY) and Alibaba in its top 10 holdings.  

If you do decide to go down the thematic ETF route, make sure you check how diversified it is as it may have a very high weighting to a handful of companies. iShares S&P 500 Information Technology Sector UCITS ETF (IUIT), for example, has 21.7 per cent in Apple and 19.2 per cent in Microsoft.