The technology sector was amongst the best-performing equity sectors over the last three and five years, returning 13% and 11% on an annualised basis, respectively. Over the past year to the end of May 2016, the MSCI World Information Technology index has been broadly flat in US dollar terms.
It is impossible for any tech fund to have an overweight position in Apple
This short timeframe has seen large swings, with a low reached in February this year, only for the market to then recover that lost ground. Amid an uncertain economic backdrop, this sector has continued to outperform the wider market as measured by the MSCI World index, which was down almost 4% over 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 2016, Apple accounted for over 12% of the MSCI World Information Technology index, making it comfortably the largest index constituent, and meaning that 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 size in any one stock, it is impossible for such funds to hold an overweight position in Apple.
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.
Who is Actively Underweight Apple?
Active technology fund managers with the largest underweight positions in Apple (AAPL) are often those that focus on companies lower down the market-cap scale, seeking to find firms with disruptive new technologies that 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 life cycles and could also be under threat from the new and emerging disruptive firms within the fast-evolving sector.
Over the last 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 of course 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.
Despite Apple’s recent performance, this hasn’t necessarily resulted in strong overall performance for funds focused on stocks lower down the cap scale. Small- and mid-cap technology stocks have underperformed their large-cap counterparts over this period, affected by a flight to safety as investors have sought the perceived shelter of larger-cap names in the volatile market environment.
At the other end of the scale in performance terms is Facebook (FB); another of the large index constituents but one that has continued to go from strength to strength. Its recent update reported strong growth in advertising revenue and total revenue, as well as encouraging numbers on the growth of user engagement.
Despite its status as one of the largest players in the sector, Facebook is still viewed positively by fund 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.
Apple is Not the Only Major Player
Google’s parent company Alphabet (GOOG) 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 amongst the technology funds covered by Morningstar’s fund analysts. However, given that the two lines of Alphabet stock combined make up almost 10% of the MSCI World Information Technology index, it is another company in which funds cannot maintain a significant overweight position relative to the benchmark.
