Investing Basics: Investing in technology with investment trusts

Investing in technology has been the story of the last ten years in equities markets. Companies in Silicon Valley in particular have driven a huge proportion of the returns that the stock market has seen globally since the financial crisis of the late 2000s.

 
Market analysts at Ned Davis Research found that removing Facebook, Amazon, Netflix, and Google-parent company Alphabet from the S&P 500 reduced the index’s total return by almost 10% from 2015 to 2020.

Those four companies, along with others like Microsoft and Apple, vastly outperformed the wider US stock market during that time, along with almost all other major listed businesses across the globe.
 

The trouble with hype

 
Understandably, that has meant many investors want to get exposure to this segment of the market. Taking an active approach might even be seen as a must, given the potential for outperformance these companies are thought to possess.

Doing so arguably carries a higher level of risk with it though. Lots of technology companies that have emerged over the past decade are speculative and may have a high valuation predicated on future profitability.

If that profitability never arrives or isn’t in line with the markets expectations then share prices can fall dramatically. We saw this repeatedly in 2020 and 2021, two years that saw record amounts of cash being raised via new initial public offerings (IPOs).

Lots of these businesses had never turned a profit and still haven’t at the time of writing. With enthusiasm dampening for many of them, that has led to major sell-offs and companies losing a huge amount of value relative to their all-time highs.
 

Sorting the good from the bad

 
What this goes to show is how hard it can be to pick the winners from the losers, particularly in an area of the market that’s seeing a surge in interest.

Looking at technology’s historical outperformance, it’s easy to be duped into believing all companies in the industry are likely to do well and generate strong returns for shareholders as a result.

Not only is this not true, it’s arguably a much riskier area than others. As many listed technology businesses at the time of writing are valued highly based on future outcomes, there are arguably relatively more unknowns than in other areas of the market.

To give an example from the past, in the early 20th Century, there was a massive boom in the nascent US car industry. Thousands of companies were set up and received backing from investors. Today just three companies, Ford, Stellantis, and General Motors, control the overwhelming majority of the industry.

Identifying those three businesses at the beginning would have been a hard thing to do and, just like today, it’s easy to imagine investors thinking a rising tide would lift all ships when that ultimately wasn’t the case.
 

How investment trusts can support tech investors

 
One way investors can try to avoid these traps but still have an active exposure to the market is by buying shares in an investment trust that focuses on technology companies.

Investment trusts are pooled investment funds. They are set up as publicly traded companies and have shares listed on an exchange as a result. To get exposure to a trust’s investments, you just have to buy some of its shares.

For technology investors, the main benefit that a trust provides is that it gives you access to an actively managed portfolio, run by a team of professional fund managers.

There is obviously no guarantee they will generate returns, but it’s a simple way of handing over the investment process to a group of people that are typically experts in their field. Technology investors that want an active exposure to the market but don’t want to manage their own portfolio may find this appealing.
 

Structural benefits

 
Aside from the approach they take to the market and the management skills they provide, investment trusts also have structural benefits that can make them more attractive than other types of funds.

For one thing, buying and selling an investment trust’s shares does not impact its underlying portfolio. The separation between the two means an investment trust does not have to hold a huge amount of cash and can generate a higher total return by putting more money into the market.

This is not true of open-ended funds. When investors take money out of them, open-ended fund managers have to use their own holdings to give them their cash back. To do this, they typically have to hold a larger amount of cash in case there is sudden demand from investors. Doing this creates a drag on performance because that cash is sitting in a bank account and not generating any returns, aside from any interest the bank may provide.

Aside from this, investment trusts can use gearing to enhance their returns. Gearing is borrowed money and can be used to make further investments that generate excess returns for a portfolio. It is worth noting that this can work the other way around too, as gearing will exacerbate investment falls.
 

Technology investment trusts in 2022

 
The Association of Investment Companies currently lists four investment trusts that specialise in technology companies. There are arguably a lot more than that if you factor in venture capital trusts that invest in earlier stage businesses, although it should be noted these are structured differently to investment trusts and typically invest in riskier, early-stage companies.

There are also investment trusts that don’t invest specifically in technology but may have a sizeable exposure to companies in the sector. These may suit some investors if they want to blend together some of their investment goals into one trust but are less likely to appeal to those looking for a tech-only fund.

In terms of performance, only two of the technology investment trusts have been active for more than five years – Allianz Technology Trust (ATT) and Polar Capital Technology (PCT). The former has generated total share price returns of 782.3% over the past 10 years up until March 31st 2022. Polar Capital generated 476.6% over the same period.

In comparison, open-ended companies averaged total returns of 393.4% over the past decade, substantially below the two trusts.