Tech stocks versus tech funds

As far as equity fund performances go, technology funds seems to be back with a vengeance. These funds have outperformed all other equity fund categories in the past year.

No doubt their returns have been aided by the 'low base effect' and the good performance of technology bigwigs in the past two quarters.

The fact that most technology funds underperformed in 2003 also helped their performance in 2004. But that is only part of the story. The other part is that most technology funds have lagged behind the benchmark BSE IT index.

Fund managers point to the skewed weightage in favour of large caps in the index as compared to the more even weightage in their own portfolios as the reason for the underperformance. Is the trend likely to continue?

While analysts and fund managers are optimistic about the future of technology stocks, it is a different matter whether it makes sense for investors to go for technology funds.

A look at the year-on-year performance of equity fund categories reveals that tech funds are leading the pack. While the tech category gave returns of 47.71 per cent, followed by pharma funds (41.87 per cent) and tax-saving funds (38.80 per cent).

Diversified funds, which led the way in 2003, come up next with returns of 35.37 per cent. Index funds managed returns of only 20.57 per cent. Considering the general upturn in the fortunes of IT stocks of late, as evidenced by the fact that the BSE IT Index is currently ruling near its 52-week high level, that is no surprise.

However, it is important to note that technology fund returns have lagged behind that of the BSE IT Index (54.08 per cent). Among tech funds, Templeton Mutual Fund's Franklin Infotech Fund was the only one to beat the benchmark technology index and leads the pack with returns of 60.97 per cent for the past one year.

Now if you are wondering how all save one of these funds have managed to underperform the BSE IT Index, here's the answer. The BSE IT Index gives a weightage of more than 50 per cent to Infosys and almost 90 per cent of the index is constituted by Infosys and the other three big stocks, TCS, Wipro and Satyam.

So unless tech funds imitate the weightage in the index in their own portfolios, they are more than likely to lag behind the index. "There is too much weightage for Infosys in the IT index," says Rushabh Sheth, head of equities at Kotak Mahindra Mutual Fund. 
 
"In other words there is too much risk associated in one stock of the index. So when Infosys does well, funds don't have a choice but to increase their exposure to match up to the benchmark performance," notes Sheth.

Though funds have raised the issue of this skewed weightage in favour of one stock, the fact of the matter is, as things stand now, any less exposure than that in the index for big stocks, especially when they are doing well, will mean funds will struggle to catch up with the benchmark.

Tech stocks are booming
Even so, as far as funds go, technology funds have done better than the rest in the equity category. According to Anup Maheshwari, senior vice-president and head of equities at DSP Merrill Lynch Mutual Fund, there are a few reasons behind the good returns of technology funds in the past 12 months. 
 

"At the start of the year, the technology environment was not very clear. People were cautious on technology because pricing power was not certain and the rupee was appreciating considerably at that point," says he. "So technology stocks underperformed before they reverse course."

With the US economy also starting to do reasonably well, Maheshwari feels that there is some pricing power that is slowly coming into the sector.

"But more importantly for IT companies, it is the deeper mining of clients that is getting them higher billing rates. The problem is that at the start of the year, stock prices were not factoring in these things. Now the prices have started factoring in these points and they have outperformed," he points out.

The fact that Indian IT companies have also managed to produce two very good quarters in a row (June and September 2004) is also a cause for cheer.

"Volumes started improving in the technology sector. Companies themselves were sounding a lot more confidant after the first quarter of this calendar year. They seem to be positive on their earning visibility. The momentum has just continued and they have managed to produce two good quarters in a row," says Maheshwari.

Add the fact that the rupee started depreciating again against the dollar, and there you have a picture of a mini turnaround in tech fortunes.

Betting on the big boys
Mutual funds have been adept at changing with the times. A look at the portfolios of leading tech funds in October 2003 reveals that they were saddled with several mid-cap stocks like E-Serve International and MphasiS BFL in the top 10, while leading stocks like Infosys, Wipro and Satyam were accorded lower allocations compared to the present. Cut to October 2004, the biggies have made a strong come-back, backed up by good performances. 
 

While the shift has happened gradually over the past 12 months the change in fund managers' approach is clear - they are betting on the big boys right now. The entry of TCS and Patni into the markets has also given them more options.

While Kotak Mutual Fund's Technology Fund had only a 22.58 per cent exposure to Infosys in October 2003, it has been almost doubled to 44.41 per cent at present. "We have shifted more towards the large-caps in the past 12 months," notes Sheth.

"Large companies have done better during the period and they seem to have more traction going forward." The fund also had an 8.31 per cent exposure to E-Serve in 2003, while it is completely out of favour with the fund right now.

In fact E-Serve has largely been ignored by funds these days, after occupying a prominent place in may portfolios in the first half of the past 12-months.

As for Templeton Mutual Fund's Franklin Infotech Fund, its holdings in Wipro and Satyam were 4.42 per cent and 13.71 per cent respectively in October 2003. As of now, the fund has increased its holdings to 13.66 per cent and 10.19 per cent respectively.

However, funds like SBI Mutual Fund's Infotech Fund and UTI Mutual Fund's Software Fund have largely been loyal to the big stocks like Infosys, Wipro and Satyam throughout the 12-month period.

While the latter's holding in Infosys was 20.34 per cent in October 2003, it has come down marginally to 19.56 per cent presently. Its exposure to Wipro and Satyam has also remained consistent for the past year.

In fact, all tech sector funds (barring Alliance Millennium which has MphasiS BFL as the top holding at 17.24 per cent) now have Infosys as their top holding, followed in most cases by Wipro. The next berths in the list are for heavyweights like Satyam and TCS. 
 

According to Maheshwari, even though the invisible universe for tech funds remains pretty much the same, the focus is shifting more to the larger players. The shift to large-caps has come on the back of solid reason.

"It is the larger players who are able to attract more volumes and more incremental business. Scale is becoming an issue clearly. Larger companies are able to do better. Smaller players are not able to match them," says he.

Clearly the gains in stock prices of top players have vindicated the fund managers' preferences. While Infosys gained 60.83 per cent in the past 12 months, Wipro's stock has appreciated by 46.83 per cent, while that of Satyam has moved up by 22.20 per cent. MphasiS BFL, which has been accorded lesser exposure this year,has declined by 1.13 per cent.

The preference of fund managers towards large-cap technology stocks raises a few questions. By their own admission large players like Infosys, TCS and Wipro are likely to do well in the longer-term while smaller players may find it difficult to outperform.

The fact that the weightage of the top four scrips in the BSE IT Index amounts to almost 90 per cent means that, unless funds follow a similar strategy, they are likely to underperform the index, if the sector is doing well.

Even though leading tech funds like Franklin Infotech Fund and Kotak Tech Fund are quite heavily skewed in favour of large caps with almost 75 per cent of their portfolios in the top five stocks, they are unlikely to go the whole hog and imitate the benchmark IT index, given the inherent risks. In other words, this could well mean that they will continue to underperform the index.

Given the scenario, there is a case for the argument that it may be better for investors to invest directly in the big technology stocks themselves rather than pay the 2.25 per cent entry fees applicable for investing in funds.