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Spotlight on: Large-Cap Investing
Putting the Tech Sector Under the Microscope
March 22, 2001
From 1995 to 1999, US technology stocks in the Russell 1000® Index outperformed the broad market by over 15% a year. As a result, many investors continue to direct assets to any fund with a technology label — even following last year's correction.
Ron Dugan, Russell Large Cap Portfolio Manager, asserts that many investors have become addicted to the above-average returns produced in recent years from technology stocks and funds.
"In 2000," Dugan said, "Financial Research, a consulting firm, reported that 33% of net inflows into mutual funds went to sectors. Of the sector inflow, 69% went to technology. Every time the market has seen a glimmer of hope, such as on January 3, 2001 when the Federal Reserve Board cut rates by 50 basis points (0.5%), a new tech rally has taken place. Unfortunately, it's usually short-lived."
Breaking down the sector map
Dugan hasn't abandoned technology. Rather, he believes that focusing on this sector as a whole represents too broad an approach. Technology includes PC manufacturers, semiconductor manufacturers, Internet infrastructure companies and, depending on interpretation, telecommunications companies. "Some of these sub-sectors may do well while others do poorly," Dugan said. "They rarely move at the same proportion or magnitude at the same time."
While Russell does not offer technology-specific funds, it does weight the technology sector more heavily into certain funds. Russell's task is to discover investment managers who understand what is happening within the tech sector and have shown the ability to maximize opportunity while minimizing risk. Dugan points to J.P. Morgan Fleming Asset Management in New York, a Russell "high-ranked" investment manager.
A formalized approach to risk management
 In early 2000, J.P. Morgan Fleming Asset Management launched a formal program to identify technology sub-sectors for its analysts. They felt a need to re-define technology to allow analysts' insights to be applied in a more focused manner, while keeping sector weights neutral to the benchmark.
J.P. Morgan restructured technology into three sub-sectors — software and services, hardware, and semiconductors. "As more companies entered technology, it became apparent that we needed to split the sector into finer gradations," said J.P. Morgan's Tim Devlin, Vice President/Portfolio Manager, Structured Equity Group. "The challenge is in balancing risk management with allowing the analysts enough room to add value."
J.P. Morgan also increased its technology analyst staff from three to five. This enables managers to narrow their focus yet retain sufficient choice in terms of stock selection. The firm also began making greater use of its analyst network. "Our technology analysts leverage our other analysts' relationships with senior managers to see where IT spending is going," Devlin said. "They can talk to chief information officers and find out what they like and don't like. This gives us sharper insights as to where growth will occur and who will gain market share."
A sector-neutral approach
To cushion investors against market shocks, J.P. Morgan takes a sector-neutral stance, avoiding sector timing and focusing on individual stock selection. Managing risk includes matching overall technology weighting to benchmarks, such as the S&P 500 or Russell 1000®, then weighting its sub-sectors as well.
J.P. Morgan managers still retain the freedom for what Devlin terms "thematic play." Managers can identify sub-sectors or components that may get hot, then implement their choices through individual stock selection.
"For example," Devlin said, "five or six years ago, our most senior tech analyst believed that technology would become a utility — almost heresy at the time. She pointed away from PC-oriented companies to companies in the networking and Internet environment — server companies like Sun Microsystems, storage companies like EMC and data networking companies like Cisco."
It is forward thinking that analysts and investors must use in decision making. Devlin says, "this requires a longer-term approach. The key drivers for investors are what will be the fastest growing markets in the future and who will gain market share fastest."
Has technology bottomed out?
J.P. Morgan's technology analysts believe that the 2001 marketplace will get worse before it gets better. The Nasdaq hitting a two-year low twice in February is fodder to their point. This raises the question about sector timing.
The signs of sector weakness aren't exactly reasons to pull money from technology. "Even though earnings seem to be heading lower," Devlin said. "It doesn't mean that the market will behave rationally and follow downward. That's why timing doesn't work. There's nothing to prevent tech stocks from bouncing back at any time."
Pain and patience
There's no reason to believe that technology won't always be a prominent sector considering the importance of its applications on everyday life. Nonetheless, a healthy dose of pessimism is also not unwarranted according to Russell's Ron Dugan. Investors who haven't painted themselves into uncomfortable corners by investing solely in certain sectors, should simply realize the benefits of a broad, future-centric portfolio.
"Sectors should complement your overall portfolio," Dugan said. "It's important to stay diversified outside of technology just as it's important to be diversified within the tech sector. The greater the profit potential, the greater the risk. That's why Russell's MULTI ASSET MULTI STYLE MULTI MANAGER™ philosophy makes more sense than ever."
Copyright© Frank Russell Company 2001. All rights reserved. Date of first use: 03/22/01.
For further information about these contents, please contact Russell Investments Canada Limited.
This is a publication of Russell Investments Canada Limited 2001. It should not be construed as investment, legal, or tax advice. The contents are intended for general information purposes only, and you are urged to consult your own investment, legal, or tax advisor concerning your own situation and any specific investment questions you may have.
NASDAQ: National Association of Securities Dealers Automated Quotation.
Russell 1000® Index is an index of 1,000 securities issues representative of the US large capitalization securities market.
The S&P 500 covers 500 industrial, utility, transportation, and financial companies of the US markets (mostly NYSE issues). The index represents about 75% of NYSE market capitalization and 30% of NYSE issues.
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