Technology was among the best-performing equity sectors during the past three and five years, returning 13% and 11% on an annualised basis, respectively.
Over the year to the end of May, the MSCI World Information Technology index has been broadly flat in US dollar terms. In this short timeframe there have been large swings, with a low reached in February, only for the market to then recover lost ground.
Amid an uncertain economic backdrop, the sector has continued to outperform the wider market as measured by the MSCI World index, which was down by almost 4% during the period in US dollar terms.
One particular headwind for the performance of the technology index has been Apple’s share price falls. As of the end of May, the company accounted for more than 12% of the MSCI World Information Technology index, making it comfortably the largest index constituent, meaning its performance exerts a large influence on the overall performance of the index.
Given that funds subject to Ucits constraints are restricted to a maximum 10% position in any one stock, it is impossible for such funds to hold an overweight position in Apple.
Under the influence
The magnitude of a fund’s structural underweight position in Apple will therefore constitute a significant component of its benchmark-relative performance, given that the stock has such an influence over the performance of the index as a whole.
Active technology fund managers with the largest underweight positions in Apple are often those that focus on companies lower down the market-cap scale, seeking to find firms with disruptive new technologies they believe can grow strongly to become the sector’s winners of the future.
Such managers typically allocate less capital to the larger, incumbent technology names given the belief that these companies have entered a lower-growth phase in their lifecycles. They are also regarded as being under threat from the new and emerging disruptive firms within the fast-evolving sector.
In the past 12 months, Apple’s underperformance versus the wider sector has meant a gain in benchmark-relative performance for active fund managers, with the biggest beneficiaries being those with the largest underweights to the stock.
Apple’s most recent results disappointed the market with a worse fall in revenue than expected as well as weaker guidance for the third quarter, resulting in further falls for the share price. The stock trades below Morningstar equity analysts’ estimate of fair value at time of writing.
Flight to safety
Despite Apple’s recent performance, this has not necessarily resulted in strong overall performance for funds focused on stocks lower down the cap scale. Small and mid-cap tech stocks have underperformed their large-cap peers over this period, affected by a flight to safety as investors have sought the perceived shelter of larger-cap names.
At the other end of the scale is Facebook, which is another of the large index con-stituents but one that has continued to go from strength to strength. The company’s recent update reported strong growth in advertising and total revenue, and growth in user engagement.
Despite its status as one of the biggest players in the sector, Facebook is still viewed positively by managers that focus on finding the high-growth winners of the future, as well as those more benchmark-aware fund managers who place greater emphasis on stocks at the larger end of the market.
Google’s parent company, Alphabet, has also enjoyed a strong year in terms of share price performance – although performance has been a bit softer in 2016 so far after the company missed expectations in the most recent quarter’s reporting.
Morningstar’s equity analysts still believe its shares are moderately undervalued given the sustainable competitive advantages the company enjoys. Indeed, the stock is also widely held among the technology funds covered by Morningstar’s fund analysts.
However, given the two lines of Alphabet stock combined make up almost 10% of the MSCI World Information Technology index, it is another example of a company in which funds cannot maintain a significant overweight relative to the benchmark.
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