How to Invest in Technology Stocks

Warren Buffett may shy away from investing in technology companies, but many Americans are captivated by the idea of owning a piece of "the next big thing."

After all, advances in information technology and biotechnology are more exciting than this year's dividend yield on utilities. With perfect 20/20 hindsight, people kick themselves today for not recognizing Apple's potential in 1980. To compensate for that oversight, some are eager to scoop up shares of IPOs, such as Alibaba Group, GoPro Inc., Zendesk or ReWalk Robotics.

So far this year, the Standard & Poor's 500 index's technology sector has advanced about 14.6 percent through Oct. 12. That's better than the performance of the S&P 500 index as a whole, which shows a 10.3 percent year-to-date return. However, tech is not the leading sector for 2014 or even the first runner-up. Those honors to go the health care sector, which is up 22.6 percent so far, and the utilities sector, which is up 22 percent.

Craig Hillegas, founder and president of Hillegas Advisory Services in Rancho Santa Fe, California, says investors should be cautious when buying any particular sector, including tech. He cites a Barron's survey, released at the end of every December, which shows the picks of top strategists from some of Wall Street's largest financial institutions for the coming year. In many years, including 2013, tech was the 10 strategists' favored sector.

Despite having this vote of confidence from top equity researchers, technology does not always outperform the broader index. Hillegas suggests investors remain broadly diversified rather than making specific sector bets. So-called "boring" investments, such as fixed income, can smooth returns.

"The cost of being wrong can make the difference between being able to retire and not, and you don't get a second chance at retirement," Hillegas says.

Being overly focused on one particular sector, such as tech, can have a devastating effect, he adds, citing performance during market volatility. "Sadly, looking at technology funds, they declined more than 50 percent during the financial crisis correction. And even worse than that, dating back to 2000 with the tech bubble bursting, the average technology fund plummeted 82 percent," he says.

Compounding the problem even further, many of those tech investors had invested close to the March 2000 Nasdaq peak, at the height of the dot-com bubble. For investors who like the idea of investing in a specific sector, such as tech, it's still wise to mitigate risk through asset allocation, says David Fabian, managing partner and chief operations officer at FMD Capital Management in Irvine, California.

Fabian has a positive outlook for tech, and sees plenty of room for continued innovation. He also believes tech sector stocks are fairly valued at the moment and says it's a good time for investors to get exposure to the sector. However, he advises proceeding with caution, as individual investors have the same difficulty as Wall Street professionals in predicting which sectors will lead or lag in any given year.

"I like to tell investors if they are going to do sector investing, pick two or three that you feel are going to do well. That way, you are not putting all of your eggs in one basket. You can still overweight certain areas of the market that you feel are going to outperform, but you also have diversification across a couple of different areas," Fabian says. "That way, if one doesn't do as well, some of the others will pick up the difference."

Fabian gravitates toward indexed exchange traded-funds for investing in specific areas of the market. "For managing your costs, indexing has the advantage," he says. Something as simple as the Technology Select Sector SPDR Fund or the PowerShares QQQ, an ETF tracking the Nasdaq 100 index, is often a good idea for broad sector exposure. He also likes the First Trust NASDAQ Technology Dividend Index Fund, which tracks an index of dividend-paying tech stocks.

Hillegas also says index funds are generally a preferable choice for investors who want to carve out a portion of their portfolio specifically for tech. Particularly in a nonqualified, taxable account, index funds have an edge, he says.

"For taxable investors, there's little or no capital gain distribution, so that means all the money is available to keep compounding and growing without the tax man taking a big share of the profits," Hillegas says.

However, Hillegas, who uses both actively managed funds and index funds in client accounts, says there can be a role for an actively managed tech fund if investors understand what they are buying. In particular, he notes, investors must realize that, with an active fund, past performance is not necessarily an indicator of future returns.

Matthew Moberg is a portfolio manager of the Franklin DynaTech Fund, an actively managed fund that invests in companies taking advantage of new technologies. By managing the fund's holdings rather than only owning what's in a given index, Moberg says he can include a greater variety of firms using technology to innovate.

The fund's name stands for "dynamic technologies." Moberg says that's key to understanding its objective, with "dynamic being an agent of change and technology being the application of science. So, we really think of that as focusing on growth and innovation."

Given that definition, the fund is not limited to only holding firms in the IT sector. However, tech is the largest sector represented in the mutual fund, with health care being second.

"If you focus on the most innovative companies in any economy, we think that's a way to outperform the market," Moberg says. "So we measure our success as how we perform over a cycle, which we would say is either three, five or 10 years."

The mutual fund's three-year annualized return is 18.3 percent, slightly under the S&P 500's performance. Its five-year annualized return is 15.9 percent, just edging out the S&P 500's 15.6 percent return. On an annualized 10-year basis, the DynaTech fund has returned 9.5 percent, better than the broader market's 7.9 percent return.

Moberg says he's able to deliver returns for investors by honing in on companies with room to grow. He cites the example of mature companies that may no longer be classified as "growth names."

"From our perspective, looking at active management specifically, sometimes it matters what you own, but sometimes it matters what you don't own," he says. "And not owning some of the companies that are on the back end of their life cycle can help you outperform the market as well. That can contribute, at times, as much as owning the right companies."