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Funds to play it safer in extended tech stock run

The technology sector is on a huge run, and investors are enjoying the returns from tech ETFs and mutual funds. It's easy to understand why, but it might be time to question whether an easing up is in order with technology sector bets.

Since the beginning of 2013, technology sector–focused mutual funds and ETFs have significantly outperformed the broader market. Internet stocks have led the way: While the Nasdaq is up 36 percent in the past year, the PowerShares NASDAQ Internet Portfolio (PNQI) returned 65 percent.

Lipper's universe of science and technology ETFs saw net inflows of $6.1 billion, and there have been $2.7 billion of net inflows year-to-date through Feb. 19. Science and technology mutual funds (excluding ETFs) had $1.2 billion of net inflows for 2013 and $800 million thus far for 2014.

The two top-performing ETFs over the past 14 months were both Internet-focused and, perhaps not surprisingly, were also among the most popular investments with fund investors. PNQI took in $210 million and the First Trust DJ Internet Index Fund (FDN) $960 million.

(Read more: The mystery of Google's 'other revenue')

Internet stocks, including Facebook, Google, Amazon, Netflix and Akamai Technologies, have benefited from recent earnings and rapid integration of social media and Internet commerce into daily life. This trait should remain in place, at least in the short to intermediate term, in this quickly evolving space.

This offers opportunities for both ETF and mutual fund investors—but not without volatility—especially in ETFs that tend to be more unpredictable and reflective of the activity of institutional investors. This is particularly true in the science and technology segment, where the investor base is interested in capitalizing as quickly as possible on evolving sector views.

Top 10 Performing Science/Tech Mutual Funds

Top-Performing Mutual Funds (ex-ETFs)
(12/31/12 - 2/19/14)*
Ticker
Total Return (%)
(12/31/2012-2/19/14)
Waddell & Reed Advisors
Science & Technology Fd;Y
USTFX 62.24
Ivy Science & Technology
Fund;I
ISTIX 57.59
Rydex Internet Fund;Investor RYIIX 56.34
Fidelity Select Software and
Computer Svcs Ptf
FSCSX 55.79
BlackRock Science & Technology
Oppty Port;Inst
BGSIX 53.83
Columbia Technology Fund;R5 CTHRX 52.8
Fidelity Select IT Services Portfolio FBSOX 51.49
USAA Science & Technology Fund;Fund USSCX 50.94
RS Technology Fund;Y RIFYX 49.68
Wells Fargo Advantage Specialized
Tech Fund;Adm
WFTDX 49.05
*Share class shown is the top-performing one for the portfolio. Source: Lipper, a Thomson Reuters Company

For the tech faint of heart
If you're an investor who is comfortable with inherent volatility, the global outlook for consumer electronics, mobile devices and shorter product life cycles makes a fund like PNQI an attractive intermediate-term investment option.

However, since the current tailwinds in technology favor the more dominant players in the peer group, an offering such as the Waddell & Reed Advisors Science & Technology Fund can help an investor gain exposure, while mitigating some of the downside volatility that more concentrated sector funds or ETFs could produce.

Waddell & Reed Advisors Science & Technology Fund has a solid long-term track record, with a top-quintile overall Lipper Leaders for Consistent Return rating. The fund has approximately 60 holdings and has exposure to names across the spectrum, such as Google, Twitter and Aspen Technology.

(Read more: How to think like a VC about the latest tech buzz)

For investors interested in playing niches within tech, Fidelity Investments' technology-focused funds have lower-than-average annual expenses for actively managed portfolio options, ranging from 0.81 percent to 0.86 percent annually. The average expense ratio for the Lipper science and tech fund category is 1.37 percent. The Fidelity Select Technology is a relatively conservative offering in this sector that has generated consistent return scores for several years.

Fidelity Select Technology could be relatively attractive at this point in the tech cycle for many long-term investors for both its cost structure and attention to "best ideas"—particularly as investors in the technology sector seek out long-term dominant players in the Internet and semiconductor arenas that can maintain both the appeal and utility of their brands.

Top 10 Performing Science/Tech ETFs

Top-Performing ETFs
(12/31/12-2/19/14)
ETF
Ticker
Estimated Net Flows ($Mil)
(12/31/12-1/31/14)
Total Return (%)
(12/31/12-2/19/14)
PowerShares NASDAQ
Internet Portfolio
PNQI 210 71.47
First Trust Dow Jones
Internet Index Fund
FDN 959.5 61.21
SPDR S&P Software
& Services ETF
XSW 12 48.56
iShares PHLX
Semiconductor ETF
SOXX -2 48.19
First Trust NASDAQ-100
Tech Sector Index Fund
QTEC 43.8 45.1
PowerShares S&P SmallCap
Information Tech Port
PSCT 91.3 43.98
First Trust Technology
AlphaDEX Fund
FXL 321.5 43.82
Guggenheim Invest S&P 500
Eql Wght Technology ETF
RYT 245.6 43.5
SPDR S&P Semiconductor
ETF
XSD 41.9 43.36
PowerShares Lux Nanotech
Portfolio
PXN -1.5 40.31
Source: Lipper, a Thomson Reuters Company

Dogs expecting a better day
Two tech-sector ETFs experienced notable net outflows: the Market Vectors Semiconductor ETF (SMH) and Powershares Dynamic Networking Portfolio (PXQ). These tech niches have, not surprisingly, barely stayed ahead of the S&P 500 over the past year. SMH may have also lost some appeal because of its heavy weighting (12 percent) to Taiwan Semiconductor Manufacturing Co., whose shares went nowhere in the past year.

The iShares PHLX Semiconductor ETF (SOXX) faired better last year, and investors in semiconductor ETFs have realized a wide range of percentage gains from big names in the space, including Intel, Micron Technology and Applied Materials—with Micron up near 200 percent in the past year, while Intel trailed the S&P 500 Index with an 18 percent return.

The overall outlook is improving. Memory chip–makers, equipment fabricators and other vital supply-chain producers for the technology industry are on the positive side of this cyclical industry, aided by several significant operational restructurings. Improved demand, particularly in the global consumer electronics segment, could also aid these companies in an attempt to put the choppiness of their past performance behind them. The short-term tailwinds and improved industry fundamentals remain positives for semiconductor ETFs in the coming months.

Networking stocks have generally lagged the broader sector because of some weakness in the enterprise segment and routers' changing product cycles. This is a sector to consider, since the debt levels of most companies are low and the companies generate solid cash flow, with better earnings visibility than in most other areas of technology. Juniper Networks is a significant leader in this segment; it has announced large stock buybacks to take place in upcoming months.

—By Barry Fennell, Senior Research Analyst, Lipper

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