Buy tech, sell financials

Over the past three months this series of articles has focused on three economic drivers for the next 10 years: world population growth, global debt and monetary easing and inflation.  

In the forthcoming columns I will present investment themes that will profit from the demographic, economic and political developments we are going to face.  


Investment theme: Technology  

According to Standard and Poors website the two largest components of the S&P 500 index are informnation technology, which accounts for 18.12 per cent, and financials, which represent 16.16 per cent of the benchmark. In the institutional world, when a portfolio manager is involved with pension funds or mutual funds, the internal risk controls of the firm and the bonus structure usually translate into an exposure to both sectors in proportion similar to the index. Therefore most funds’ benchmark to the S&P 500 are approximately 18 per cent in technology and 16 per cent in financials. The institutional philosophy is one of “don’t rock the boat, just beat the index by 0.5 per cent, this will guarantee bonuses and a long career… “. If the market rises by 20 per cent and you deliver 20.5 per cent you are a star. If it drops by 20 per cent and you “only” drop by 19.5 per cent, then again you are stellar. You can pass go and collect a bonus, which usually accounts for up to three times your base salary. 

As a single investors you need to decide if this quasi-indexing approach is right for you. The quasi-indexing approach guarantees to reduce the relative risk of your portfolio vis-à-vis the benchmark (the deviation versus the index) but it doesn’t consider the absolute risk of your investment, or if you prefer the possibility of losses forward. Let’s say that you greatly dislike energy stocks, would you be holding a 10 per cent weighting in them in fear of being wrong? The benchmark is at 11.04 per cent. If you answer no to this question then be aware that your mutual funds and pension funds are doing just that. 

I am of the view that professional asset managers should break out of the indexing approach and take calculated risk with their investor’s capital. The goal of all investors is to protect and grow his capital in time, not to beat a given benchmark. The benchmark approach works well in bull markets but can be painful in bear markets.  

Since 2007, except for some limited exceptions, Clover has stayed away from financials. This means that the average investor in our firm has less than 2 per cent exposure to banks and insurance companies. At the start we were worried with the bank mortgage exposures and since 2009 we have avoided the financial sector because of the lack of transparency, (JP Morgan comes to mind…). We also stayed away from financials because we expected the situation in Europe to get worse and to contaminate the globalised banking sector. The wake up call we received from Cyprus may be the start of something much bigger.  

The lack of investment in the financial sector creates an increased relative risk in our investors’ portfolios but we are of the view that it reduces the absolute risk going forward. There is no denying that financials are a growth engine in a portfolio during times of economic prosperity. However we doubt that in a rising rates environment, where banks are sitting on billions in long-term sovereign debts, we would see much value in the coming years. Therefore how should investors grow their assets without financial sector exposure? We believe in overweighting technology, healthcare and biotech.  

After experiencing the bubble of the early 2000’s, the technology sector has matured and is now focused on delivering top and bottom line returns. Who would have thought 10 years ago that Apple would pass Exxon in market capitalisation? Over the recent years technology was one of the best sectors for wealth creation and we see no reason for this to change over the next ten years. The slow growth economy the world is tangled in is a great environment for technology as increases in productivity will be key to growing the bottom line for most corporations going forward. We also believe that the love for everything electronic, demonstrated by consumers over the last few years, will continue.  

There are multiple diversified avenues available for investors to participate in the technology sector. One of the most popular is the Select Sector SPDR-Technology (XLK). XLK presents a 4 star rating from Morningstar and is highly liquid with close to 8 million units traded everyday. There is one flaw with this investment, its concentration toward its five largest holdings. The fund presents close to 43 per cent of its assets in Apple (13.6 per cent), IBM (7.6 per cent), Google (7.4 per cent), Microsoft (7.2 per cent) and AT&T (7 per cent). Therefore as these five stocks go, so goes XLK. If you can stomach the higher volatility that comes with smaller cap exposure I would recommend looking at the Guggenheim S&P 500 Equal Weight Technology ETF (RYT). This ETF invest in the same 70 stocks as XLK but invests the same dollar amount in each security, providing investors with better diversification. However there is a cost to this diversification, the fund charges a gross expense ratio of 0.5 per cent compared to 0.18 per cent for XLK. The rebalancing required for equal weight ETFs such as RYT also leads to higher transaction fees and lower tax efficiency. However equally weighted ETFs protect you against the collapse of one given stock, such as Apple in early 2013. When compared, the performance of both ETFs is similar over time.  

The other avenue, when investing in technology, is to buy stocks directly. No portfolio would be complete without at least one of the four growth leaders that are Amazon (AMZN), Apple (AAPL), Facebook (FB), and Google (GOOG). These four players, which were each providing distinct products historically, are gradually morphing into each other and will offer an amazing turf war in the coming years. It is difficult to pick the winner, therefore we recommend owning two or three of them. Our clients invest in AAPL, FB and GOOG. We sadly didn’t invest in AMZN over the last few years, judging that the stock was too pricey, a costly mistake so far. 


Next time: alcohol stocks, a reason to celebrate. 


There are multiple diversified avenues available for investors to participate in the technology sector.