Is it worth holding a technology index fund?

Occasionally I hear things along these lines:

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

It is fairly 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? Below are the reasons why I think getting a “total market” index fund is better than a technology index fund.

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 which overweights on technology has both stock market risk and sector risk.

Ultimately the reasons why I don’t hold a technology fund are similar to the reasons why I don’t hold individual stocks, it requires making a bet that a limited set of companies will have great long term performance. Making such a bet is hard given that and I don’t know the future or have deep and unique insights on the technology sector.

Share prices

The expectations that tech stocks will grow is already reflected in the current (higher) share prices. That can be inferred 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. 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.

There are many studies showing 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 greatest 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.

Historical returns

We don’t have much historical data to compare returns. Additionally, historical returns can be easily manipulated because the dates can always be cherrypicked.

The graph below (source: MorningStar) compares the returns of the Vanguard Total Stock Market Index Fund with PowerShares QQQ which tracks the Nasdaq 100 index.

Between its peak in April 2000 and its bottom in October 2002, the technology fund (QQQ) lost ~82% of its value. After the bottom it took 15 years for the technology fund to surpass the total stock market’s performance in May 2017. It looks to me that the technology fund had more risk, was more volatile and the upside was little when compared to the total stock market fund.

The graph also shows that more diversification in the total stock market fund helped reduce the severity of the 200-2002 crash – it “only” lost 45% of its value.