Best way not to get burned by tech? Use active managers

As the technology sector shows signs of heating up again on the momentum of new smartphone and tablet launches, investors might be best-served by letting professional money managers do the heavy lifting.

According to market watchers and fund analysts, the best way to play a fast-changing and increasingly diverse tech sector is to rely on active managers and to avoid the broad-market-index exposure.

“When it comes to technology stocks, you have to be selective,” said Angelo Zino, a tech stock analyst at S&P Capital IQ, a unit of Standard & Poor's.

He cited, for example, the tales of performance by such bellwether names such as Apple Inc. (APPL) and Microsoft Corp. (MSFT).

Apple shares, up about 64% so far this year, gained 25.6% last year and 53.1% in 2010.

SLUMPING MICROSOFT

Microsoft, by contrast, only recently broke out of a relative performance slump with about an 18.5% gain so far this year.

Microsoft shares declined by 4.6% last year and fell by 6.6% in 2010.

What investors could be missing by lumping the overall tech sector together and investing based on select high-profile stories are factors such as the growing challenges facing the personal-computer market, which is now being cannibalized by tablets, Mr. Zino said.

“We're looking for 50% growth in the tablet area this year, but PCs are flat,” he said.

Although tech sector mutual funds, as a broad category, have gained more than 15% from the start of the year, fund investors have followed a predictable pattern of chasing that performance instead of sitting tight and trusting the pros.

The consequences of such an investing approach can be punishing, according to Morningstar Inc. fund analyst Flynn Murphy.

“The average tech sector fund returned 21% during the first quarter of this year, following Apple's 48% gain during the period, and investors bought into the sector as the run-up was under way,” he said.

According to Morningstar, tech funds saw net inflows for February and March of $574 million and $698 million, respectively.

“As the tech sector's performance stalled during the summer, investors pulled more than $1.1 billion from tech funds in May, June and July,” Mr. Murphy said.

“And as performance picked back up again in August, investors returned to the sector, with flows following performance,” to the tune of $740 million in net inflows, he said.

“The tech sector is always going through waves of innovation and consolidation,” Mr. Murphy said. “But in general, flows are following performance.”

Perhaps more than any other sector, technology represents a stark mix of opportunities and risk, according to Gregory Heilman, a portfolio manager at Schwartz Investment Counsel Inc., a $700 million asset management firm.

INDUSTRY DISRUPTION

“There's certainly a division of tech winners and tech losers this year, and part of it has to do with tremendous disruption in the industry where products are moving from PC-based to tablet- and smartphone-based,” he said.

Mr. Heilman listed Apple, Micro-soft and International Business Machines Corp. (IBM) among the stocks that he expects will lead the winners.

But he is also banking on some value play opportunities with laggards such as Hewlett-Packard Co. (HPQ) and Intel Corp. (INTC), down 32% and 4%, respectively, this year.

“Hewlett and Intel have been suffering, but we've been taking a contrary view, and we expect them to get some boost from Microsoft's upcoming launch of Windows 8,” Mr. Heilman said.

Both Hewlett-Packard and Intel are plays on the fast-growing smartphone category, he said.

The “very general theme” that consumer PC sales will continue to be weak should also be considered against the backdrop of a broader “weak economic outlook that is not helping,” said S&P Capital IQ fund analyst Dylan Cathers.

With that in mind, he identified three mutual funds positioned to help investors take advantage of the developing category: the Buffalo Discover Fund (BUFX), Fidelity Select IT Services (FBSOX) and Fidelity Select Software & Computer Services (FSCSX).

The funds were selected by screening for the highest-ranked funds in the science and technology peer group, based on performance analytics, risk considerations and cost factors, Mr. Cathers said.

Fund performance emphasis was placed on five-year annualized returns.

The Buffalo Discovery Fund, which has gained about 20% this year, has a five-year annualized return of 5.5%, which compares with a category average of 2.2%.

Fidelity Select IT Services has gained about 18.5% this year and has a five-year annualized return of 9.5%.

Fidelity Select Software & Computer Services has gained about 20.5% this year and has a five-year annualized return of 8.5%.

Mr. Murphy highlighted two funds in the sector that have earned positive forward-looking analyst ratings: Allianz RCM Technology Fund (RAGTX) and Ivy Science & Technology Fund (WSTAX).

A key attribute of both funds is that they have shown an ability to reduce volatility within a traditionally volatile category, he said.

The Allianz fund, which has gained about 13.9% this year, has a five-year annualized return of 2.2%.

The Ivy fund, which has gained about 23.2% this year, has a five-year annualized return of 6.3%.

[email protected] Twitter: @jeff_benjamin