Is it worth holding a technology index fund?

Occasionally I hear things along these lines:

I think technology has excellent prospects and will continue to grow like no other sector. Therefore, I am willing to take an additional risk by holding a (US) technology-focused ETF so I can get exposed to its high potential returns.

It is reasonably understandable to hear that given that many people work in tech and everybody has had their lives dramatically improved due to technology. But is it worth holding such ETFs in the long run? I prefer index funds that invest in all sectors according to their market value (i.e., market capitalization) – total market funds.

In this article, I explain why I don’t increase my exposure to the technology sector beyond their market value through sector-specific index funds.

Historical Performance

Technology stocks have had an impressive performance.

The graph below compares the performance of US Technology, World Technology, US Market, World Market from 1995 to 2015. The graph shows that US Technology and World Technology outperformed the US Market and the World Market over this period.

My investment preference for equities is the World Market which had the lowest performance. I prefer the World Market due to its diversification.


Source: Global Investment Returns Yearbook 2015, Credit Suisse

It is important to note that technology stocks peaked in April 2000 and then lost 82% of their value over two years. During that period, the World market and the US market had a more modest spike and decline. This shows how diversification (of sectors) mitigates acute market declines.

The returns specific investors saw may be different from the graph above:

  • Investors usually invest periodically – the graph shows the growth of $100. Investors contribute to their portfolios regularly, which means that a smaller part of their portfolio is exposed to market declines and that they buy shares at different prices.
  • Investors may invest in different periods – From 2010 to 2019, investing $10,000 into US technology stocks (QQQ) grew to $51,610. From 2000 to 2010, investing $10,000 into US technology stocks (QQQ) fell to $6,189. These are very different experiences.

These are historical returns. The main questions are whether we are likely to see such a strong performance of equities in the future.

Sector risk

Owning individual funds and sector stocks is more akin to speculating, not investing. The market compensates investors for risks that cannot be diversified away, like the risk of investing in stocks versus bonds. Investors shouldn’t expect compensation for diversifiable risk – the unique risks related to owning one stock, a sector or country fund. Prudent investors only accept risk for which they are compensated with higher future returns – Larry Swedroe in the Quest for Alpha

A “total market fund” has holdings across all sectors (including technology) in the appropriate proportions, based on market capitalization. The total market fund, therefore, eliminates the risk of choosing the wrong market sector and only has the risk of the (whole) stock market.

A portfolio that overweights on technology has both stock market risk and sector risk.

There is a wide dispersion of performance across sectors. Not all of them beat the market. Many sectors underperform the market.

The graph below shows how only a few industries outperformed the market during the period 1900-2015. The difference between investing in the worst-performing sector (i.e., Ships) and the best performing sector (i.e., Tobacco) is enormous (a 6,000x difference!).


Global Investment Returns Yearbook 2015, Credit Suisse

The prominence of sectors in the stock market changes often.. Technology is big now, but that wasn’t always the case.

The graph below compares the presence of each sector in the US stock market in two different periods (1900 and 2020). Railways stocks accounted for the majority of the stock market in 1900 but now account for less than 1%. 


Source: Global Investment Returns Yearbook 2020, Credit Suisse

If you chose technology stocks because they are promising, you must also account for a future period in which they aren’t. “Taking a bet” on a specific sector requires having a framework for updating your thesis if new information arrives. What is your framework?

Ultimately the reasons why I don’t hold a technology fund are similar to the reasons why I don’t own individual stocks. It requires making a bet that a limited set of companies will have high long term performance. Making such a bet is hard given that, and I don’t know the future or have deep and unique insights into the technology sector. I don’t have an edge, do you have an edge?

Share prices

The current (high) share prices already reflect the expectations that tech stocks will grow. You can infer that through higher P/E ratios than the rest of the market. As of November 2018, the MSCI World index has a P/E ratio of 17.54, while the MSCI World Information Technology has a P/E ratio of 21.05 (20% more expensive).

You have to buy low and sell high to get good returns. The main question is whether you think if tech stocks are undervalued and by how much. If the prices are already high, it makes it harder for these investments to break even – they have to grow at a pace significantly faster than the general market.

Many studies show how growth stocks have historically underperformed value (a.k.a. “bargain) stocks, and the share price is an important reason behind that phenomenon.

Popularity

Rekenthaler’s Rule: If the bozos know about it, it doesn’t work any more. – William Bernstein

When a risky asset class is too popular, everybody tries to hold it (even people that don’t understand it), which raises prices, which leads to lower expected returns. Remember Bitcoin in December 2017 when everybody was talking about it?

The highest returns of a risky asset class are made by investors that get in when nobody cares about it: due to it being new or not being fashionable.

Technology is not new, and though we are far from the periods of “Irrational exuberance” of the dot-com bubble, it is still fashionable.

Everybody (informed or not) thinks that technology is the future. Therefore I’d argue that Rekenthaler’s rule may apply. If you are going to bet on it, I’d suggest you do it based on a more elaborate insight.