Tech Sector: Quiet Underperformer

[This article originally appeared in the November issue of ETF Report.]

To the casual observer, it may come as a surprise that one of the most-discussed investing sectors also has one of the poorest long-term performance records.

Despite excitement over companies like Apple, Google and Facebook, a long-term investor in the technology sector has underperformed versus simply buying the broader stock market.

Over the past 16 years, the technology sector has lagged the broader market as the dot-com bust wreaked havoc on the tech industry.

In ETF terms, during that time, the Technology Select Sector SPDR Fund (XLK | A-91) has seen a total return of 44.2% versus a total return of the SPDR S&P 500 (SPY | A-99) of 109%.

Manic Market Fallout
The drag on the technology sector shows what happens when markets are seized by manias, according to Brian Jacobsen, chief portfolio strategist at Wells Fargo Fund Management. Investors sought technology between 1990-2000 because of the investment in information technology and the blossoming of the Internet, but after the bubble burst, people became sanguine, he explains.

“I understand why people were excited about technology, and it got overdone. I think a lot of people thought, ‘We have enough. Who’s going to want to lay more fiber optic cable? Who needs to invest in tech or computers?’” he said.

Jacobsen says the longer-term lagging of the sector is really more a large-cap and medium-size cap story. Small-cap technology has beaten the broader market over time, he says, but the problem was picking who would survive.

“A lot of people are excited about technology, but they’re very skeptical about who’s going to lead. They don’t want to buy the next Pets.com. They want to buy the Amazon.com, but how do you determine which one is going to win? … That’s why a lot of people are leery of investing in technology because everything is about disruption. When everything is about disruption, it can create and destroy a lot of wealth in a very short period of time,” he said.

Picking Performance
Mark Abssy, senior index and ETF manager for ISE ETF Ventures, doesn’t completely agree with the technology sector’s underperformance. He says that outside of the dot-com bubble bursting, the technology sector has performed well.

“Outside of that event, if we’re looking even from the end of September 2002 to now, we see an annualized rate on SPX [S&P 500] of 9.27% and 14.58% for the Nasdaq as of Aug. 31. That’s a 13-year period. With a 10-year period, that gap widens,” he said.

Rather than consider technology an underperformer, Abssy says, it’s really more about mania and how those form.

“I think that technology by its very nature is more prone to mania or to bubbles than other areas simply because it’s all about innovation and new things and the promise of a better tomorrow,” he said.

Technology companies come and go, Abssy notes.

“If something is so immensely popular or fulfills such a need, ultimately it turns into a commodity item,” he said, using the defunct company Global Crossing as an example.

“They were laying the backbone of the Internet. They were doing all this undersea cable stuff. It was awesome. We hadn’t seen that in some time, and look at all the money they were going to make, and the Internet was going to rule the world. The Internet is still going to rule the world, but at the end of the day, that turns into a commodity,” Abssy said.

Looking Ahead
Jacobsen, and Chuck Self, chief investment officer at iSectors, are both bullish on technology, and believe it will outperform.

Jacobsen says he is “broadly optimistic” on technology for two reasons. First, he expects to see growth in capital expenditures by companies, which should support technology firms. Second, he says valuations are reasonable.

“Capital expenditures have been somewhat lagging over the last few years, and I think we can argue that companies have not been investing enough in technology ever since the tech bubble burst,” he said.

Additionally, in the past few years, technology companies have started to generate much more free cash flow, and valuations haven’t caught up with that cash flow, Abssy says.

Self agreed that companies will start to increase their spending on technology, and he expects to see “significant” spending by consumers on the Windows 10 operating system.

Different Tech Sector ETFs
Self said he likes the iShares North American Tech ETF (IGM | A-86). It represents both U.S. and Canadian technology companies and includes stocks from the S&P Total Market Index. He says the fund is also not so heavily weighted in Apple that it overwhelms the fund, unlike other technology funds.

“I don’t have a view on Apple, but I would be concerned about any fund with a 15-20% weighting in any company,” he said.

JJ Feldman, portfolio manager at Miracle Mile Advisors, also likes technology, but is taking a more diversified approach in his current investment. Previously, he owned XLK and the First Trust Nasdaq Technology Dividend Index Fund (TDIV | A-65).

This year he’s invested in the PowerShares QQQ (QQQ | A-64). Feldman says what draws him to QQQ is that it’s more diversified than the average technology fund, and it’s beaten the S&P 500 for the past few years.

“Compared to the S&P 500 year-to-date, despite everything, QQQ is up 1.3% [as of Sept. 28], and the S&P 500 is down 4.77%,” he said, He believes part of that is the diversity of the fund, which is not straight technology.

Warning Signs Flashing
One ETF fund firm is wary about the technology sector and the broader market in general. Ryan Ballantyne, executive vice president of sales and trading at Reality Shares Advisors, says its Guardian indicator, which uses a factor-based approach of momentum in combination with volatility, has is negative on technology and other sectors.

The firm said the short-term moving average price trend for technology fell below its long-term average on Aug. 31, and its volatility levels surpassed long-term averages by the market close on Oct. 12. It’s the fifth sector to turn negative in the Guardian Indicator, after health care, energy, utilities and consumer staples.

Yet Ballantyne says that, from a pure fundamental perspective, the technology sector is strong when looking solely at its dividend payments.

“IT has been the biggest contributor to dividend growth over the last several years,” he said, noting that as of 2014, Nasdaq dividend payments were just under $60 billion, versus just over $7 billion in 2004.

Looking at dividends versus just share price may be another way to play technology, Ballantyne says.