Mutual funds are pouring over technology stocks, and it is not hard to understand why. U.S. Technology is among the top performing sectors so far this year – something which has translated into big gains for funds overweight in the sector. But, it also begs the question, are investors’ appetite for tech stocks becoming too risky for them to stomach later?
Tech Bull is Raging and Investors Are Cool about It
According to a Bank of America Merrill Lynch report, large-cap active equity mutual funds reached a record-high overweight of 25% (+5.8 percentage points increase) in U.S. Technology sector relative to the benchmark in July (as reported by CNBC). This overweighting could well be a self-fulfilling cycle – the Technology Select Sector SPDR Fund (XLK) has climbed around +19% as of end-July since the start of the year, and mutual funds have probably been buying into the momentum by letting their positions grow in the sector, only to reinforce the tech rally.
Investors seem to be quite complacent about it too. Technology stocks have been trading with the implied volatility way below that of Utility stocks. That’s rather surprising, given that Technology has some of the most volatile earnings among sectors and is potentially far more cyclical than companies supplying our day-to-day needs of gas and power. Is this than ‘the calm before the storm’ for tech stocks?
To be sure, U.S. Technology’s fundamentals are on a strong footing. The S&P 500 Technology earnings grew at a record +17% in Q1 2017 year-over-year, and the Q2 figure is estimated to come in at a solid +15% (according to the latest Zacks Earnings Trend report). But, question is – how much of funds’ overweighting the sector is justified by fundamentals versus complacent momentum?
Are Funds Blinded by Tech’s Momentum?
When a sector experiences high returns and low volatility, many investors tend to underestimate risks and keep piling on the sector – more so, if the sector has had positive earnings growth in recent times. This could be a potential factor driving the current overweighting of tech by funds. And that makes these funds that much more vulnerable to pullbacks. That’s because there is only so much room that’ll be left for further price increases in overcrowded sectors or stocks. And when it gets too ‘hot’, investors will rush to exit all at once, thereby potentially competing away each other’s returns. The less diversified a fund or portfolio is across different sectors, the more the downside risks from their overweight positions.
Bottom Line for Investors
Whether or not mutual funds feel ready to taper off their tech exposure yet, it makes sense for investors to leverage the Technology’s strong fundamentals without letting the ‘herd mentality’ get in the way. That is achievable through increased selectivity in tech investments and adequate portfolio diversification. Ultimately, fundamentals will drive long-term returns in any sector or security. But for the potential roller-coaster in between, adequate diversification across less-correlated sectors and asset classes is what will cushion the downside risks.
Having said that, we understand that not every investor may feel confident enough to rise above the crowd without the fear of losing out. More importantly, they may not be sure which strategy to adopt to maximize gains, in an environment of increasing integration between financial markets and rising economic/policy uncertainties. That’s why, at Zacks Investment Management, we leverage our in-house independent and unbiased research and tools to get a better in-depth understanding of fundamentals across sectors, countries and asset classes. We use this to build customized diversification strategies for every client to mitigate downside risks, while keeping in mind their individual financial goals and risk tolerance. If you want to understand which strategy suits your needs and time horizon, feel free to get in touch at 1-888-600-2783 for a free portfolio review. We’ll be happy to answer your questions and also give you more details on our services.
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