From the July 2006 issue of Wealth Manager Web • Subscribe!

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If exposure to technology has bee n driving your clients' portfolios up ward, you probably have teenagers to thank. The ubiquitous Apple iPod, launched in October 2001, quickly became standard equipment for high school students. It changed the face of music sales overnight and set off a wave of demand for MP 3 players that has only recently begun to slow. In fact, consumer-oriented products have been on a tear of late, with a spate of new technologies ranging from high definition TV s and digital recorders to next generation video games and MP 3 players driving demand. So it is no surprise that many financial advisors and mutual fund managers have been stepping up their exposure to technology stocks. Of course, not everyone is embracing the sector--and many investors are still haunted by the dot-com bust--but today, tech is certainly worth a second look.

For those betting on its return, technology has proven promising thus far, and not necessarily dependent on glamour items: As many fund managers increase their technology exposure, the consensus seems to be that semiconductors may be the next hot area within the sector. Still, the approaches they are taking to tap this portion of the sector are as varied as the products themselves.

Ian Warmerdam, director of London-based Henderson Global Investors' Global Technology Fund, believes investing in companies focused on the hard disk drive segment--as well as those producing the raw materials and equipment used in its production--is one of the best ways to tap this demand. "There's more and more data being stored on digital devices; therefore, disk drives are being used in products they've never been in before," says Warmerdam. Hard disk drives have become an integral part of a multitude of popular new consumer technologies--everything from set-top boxes to digital cameras. In fact, Electronics.ca, a company specializing in market research for the electronics industry, predicts that the worldwide market for hard disk drive semiconductors will grow nearly 10 percent by 2009, to $4.61 billion--up from $2.91 billion in 2004.

With $750 million in total assets under management across a number of pure technology funds, Warmerdam says he is broadly enthusiastic about the sector. "We've seen some real improvement over the last couple of years, and we're expecting that to continue over the next couple," he says. Another side of the sector he has been focusing on is satellite navigation where, as pricing drops, personal navigation devices become more affordable. Although consumer adoption of these devices has only begun picking up--it is currently much higher in Europe than in the U.S.--Warmerdam is betting on mass-market penetration. And with huge barriers to entry for new players in this particular market, he has been actively investing in the few companies that have already procured a hold on manufacturing these devices and the intellectual property for the supporting data and mapping software.

The Internet is another area of the tech sector attracting interest. "People are spending somewhere around 20 percent to 30 percent of their media time on the Internet now," says Stephen Shipman, co-portfolio manager of the Touchstone Microcap Growth Fund. Shipman says that figure encompasses all other competing media--from cable TV to newspapers and magazines. At the same time, however, he notes that there is still a significant discrepancy between the amount of advertising taking place online and in more traditional media, leaving room for substantial growth in online advertising. This fact has not been missed by traditional advertising outlets such as newspapers and magazines, which have also awakened to the realization that the Internet has become a necessary ingredient in advertising campaigns. As a defensive tactic, as well as a means of catering to their existing advertisers, traditional media companies are driving the success of online advertising, becoming more and more aggressive in acquiring and building their own Internet properties. Shipman says roughly 36 percent of the $100 million under management in the Touchstone Microcap Growth Fund is currently invested in technology.

Not surprisingly, Ryan Jacob, portfolio manager for the Jacob Internet Fund, is also extremely focused on online advertising. With $120 million under management, Jacob's fund focuses on companies that derive the majority of their revenue on or from the Internet. In fact, Jacob is even broadening his online bet to include Chinese Internet companies. "A lot of Internet companies are starting to pull away and really become leading brands in China, specifically the portals that have the most traffic," says Jacob.

The number of Internet users in China is second only to the United States, and Jacob says China might become number one within the next five years. Based on that thinking, he currently has 15 percent to 20 percent of his portfolio invested in Chinese Internet companies. "Most people think these companies are very speculative--and they are to a degree--but they're actually very, very profitable," he says, adding that the country's low labor costs allow these companies to benefit from rich margins.

Beyond online advertising, the Internet is also attracting investment interest among the numerous business lines it has been helping to drive--from wireless access to voiceover IT. In particular, online data aggregation has helped spur businesses within the wireless phone industry and even competition between the cable providers and the Bell phone companies.

As the Bells have begun adding video and content delivery services to their business lines, the cable companies have added voiceover IP (VoIP) services at a fraction of the cost charged by the Bells. This convergence, which is driving demand for cable equipment and boosting the stock price of cable equipment and network companies, has caught the attention of institutional investors. "A lot of these cable equipment companies are interesting longs because they're seeing a resurgence of spending by the cable companies that they haven't seen in years," said the portfolio manager for a technology hedge fund. "What's interesting is finding companies that can actually sell to cable companies as well as telecom companies--those guys are going to do extraordinarily well."

Video on demand (VOD) is another area where the cable companies are being forced to compete with satellite and online content providers. The faster release of content by the movie studios has made VOD offerings more compelling for consumers and is driving demand for these services.

According to Jeff Donlon, a senior analyst with Manning & Napier Advisors Inc., "Service differentiation has become more difficult. At the end of the day, all of these providers are having to add new technology." On top of that, with much of the existing network equipment in the telecom industry having been in place for five to seven years, Donlon predicts a need for extensive upgrades in the near future as well. "We'd rather play the equipment guys who are really the 'arms dealers' in this communications war," he adds.

As these services drive demand for consumer technology products, it is no wonder the companies specializing in these devices--from set-top boxes and personal digital assistants to next generation mobile phones and MP3 players--have become popular among investors. Some fund managers, however, are beginning to question the longevity of the trend.

Alex Vallecillo, a senior portfolio manager who runs the Allegient Midcap Value Fund for Allegiant Asset Management, views the current popularity of consumer-oriented technologies as a red flag. "The consumer has been strong, but we're not playing that as a theme because, to some extent, we think it's already been overplayed," says Vallecillo. With interest rates rising, the housing boom slowing and the refinancing trend grinding to a halt, he predicts a decrease in consumer spending on technology is likely to follow. But that skepticism hasn't been enough to deter his commitment to the technology sector. Allegiant Midcap Value Fund, he says, with roughly $110 million under management, is currently overweight in technology, with 11 percent of the fund invested in the sector--just slightly above its 9 percent benchmark.

Vallecillo's approach to technology investing has been to look for stocks he believes are undervalued. And, oddly enough, he has identified candidates among some of the sector's best known names--Dell and Intel, among others, whose stocks both recently hit their 52-week lows.

While software and PC companies such as Microsoft and Dell remain cornerstones of the sector, after years of major developments and upgrades that compelled consumers to rush out and buy the latest products, demand has ground to a halt. Innovations in the personal computer market have become fewer and farther between, and consumers no longer feel the need to upgrade every time a new software version is introduced. Instead, as new technologies and products such as high definition TV have become readily available, and prices have come down, consumers have shifted their focus--a shift that is taking its toll on some of the sector's large-cap stocks. Vallecillo, however, is among a small group of fund managers taking a contrarian view of the negative sentiment currently surrounding those tech large-caps.

Jacob is making a similar bet. Though the Jacob Internet Fund tends to be biased toward small- and mid-cap stocks, the fact that many of technology's bellwether companies are currently trading at only 15 to 20 times earnings, leads him to find some of the sector's large-cap stocks attractive investments. "Microsoft and Intel don't have the dominating market presence that they had 10 years ago, and that worries people," says Jacob. "But when you look at their market shares in their respective segments, these are shares that any competitor would still envy. So I think it's being a bit harsh to call them 'yesterday's news.'" Instead, investors who have been actively buying up these stocks are betting that near-term introductions such as Microsoft's impending Vista operating system, NAND Flash architecture and lighter laptops with longer battery life will be enough to drive another wave of demand for laptops and PCs within the next few years.

And even if interest rates do curtail consumer spending, some industry observers believe the impact on demand for consumer technology will be minimal. "Consumer spending in the technology arena won't erode that much," says Joseph Eshoo, a senior equity technology analyst for HighMark Capital Management. In fact, he notes that consumer spending overtook enterprise spending roughly a year-and-a-half ago, and he believes it is unlikely that pattern will shift back anytime soon--if ever. "Technology is being extended further into people's daily lives, whether it be an iPod or an automobile with global positioning, and I don't see that ever leveling off or pulling back," says Eshoo.

Still, some fund managers continue to take an extremely conservative approach to investing in the technology sector, overlooking trends and ignoring the latest "hot" area in favor of solid company fundamentals. For example, Paul Davis, portfolio manager of the Schwab Technology Fund, takes an extremely broad approach by investing in larger tech stocks with market caps of $150 million or more and relying on a formula that looks solely at a company's fundamentals, valuation, momentum and risk. Based on this formula, Davis says his fund has recently reduced its weighting in software companies to 36 percent--down from 42 percent last March--yet has raised its weighting in semiconductors to 23 percent--up from 17 percent. "You're seeing lots of managers who want to buy the next technology," says Davis. "But we tend to favor companies that are in the blend space--that have growth characteristics, but that aren't priced so high that future earnings can't catch up."

Financial advisors seem to be equally cautious when it comes to technology these days. Though sentiment toward the sector has definitely improved since the dot-com bust, investors have not totally forgotten its fallout.

Jerry Miccolis, a senior financial advisor with Morristown, N.J.-based Brinton Eaton Associates Inc., believes the risks of investing in technology companies far outweigh the benefits. He steers his clients almost entirely away from the sector. "As far back as the different sector indexes have existed, technology has had one of the nicest returns around. But it is too volatile, and that volatility eats away at the returns," says Miccolis. "On a compound-growth basis, the sector has a pretty poor return. So, even though it might average 10 percent, you end up with fewer dollars in your pocket than you would with a steady 8 percent investment." Brinton Eaton has around $400 million under management for about 200 clients.

Another advisor who is not a huge advocate of the tech sector is Greg Zandlo, president of Minnesota-based North East Asset Management--particularly since most of his clients favor a more conservative approach toward investing. Nonetheless, Zandlo believes it's necessary to have at least 1 percent to 3 percent exposure to technology in any portfolio. To achieve that exposure, he avoids stock picking and relies instead on ETFs to access the sector.

At the moment, however, he says one exception to his individual stock picking aversion would be Microsoft, which he believes is currently undervalued. "Microsoft is the one stock from a technology standpoint that would really pique my interest from a valuation perspective," says Zandlo. Though the stock has suffered alongside the sector's other bellwethers, from a long-term perspective he believes it is an example of a company where next generation products and the company's dominance still make it a promising business. At the moment, however, Zandlo's reliance on ETFs to tap the technology market seems to be the most popular approach among financial advisors.

"Investors should have exposure to all sectors of the market, but not with the approach of 'Oh, tech's going to be hot now,'" says Jeff Broadhurst, a financial advisor with Philadelphia-based Broadhurst Financial Advisors Inc. "They should have exposure to tech through a globally diversified portfolio of index funds. If you buy a domestic stock fund, you're going to have a percentage in there that is tech--a percentage reflective of the sector's weight in the overall economy."

Sander Gerber, chairman and CEO of XTF LP, a financial advisory firm specializing in ETF-based portfolios, says such thinking has driven a noticeable increase in the number of investors using ETFs to gain exposure to technology in recent years--not only among financial advisors, but among institutions and mutual funds as well.

"If you're going to invest in technology, picking an ETF is your most efficient way," says Gerber. On top of the transparent nature of ETFs and the fact that they provide diversified exposure to the sector, he says the tax benefit of the vehicles has also been a draw: Investors can put off capital gains payments until their final sale of the funds--a particularly attractive benefit in technology where year-end capital gains taxes can be quite substantial. But, above all, perhaps the most attractive feature of ETFs within technology is that investors can trade in and out of them on a moment's notice at any point during the trading day--a rapid escape option in the event of another meltdown within the sector. ETFs are also attractive because, unlike mutual funds, investors can trade them on margin.

Ongoing investor apprehension about the tech sector is also keeping some financial advisors on the sidelines. "Our investors who invested in the sector and went through the downturn are still completely shy," says Diane Pearson, director of financial planning and a financial advisor at Pittsburgh, Pa.-based Legend Financial Advisors Inc., a firm with roughly $290 million in assets under management. She says the sector will have to demonstrate a few more years of strong returns before most of her clients would be willing to be exposed again.

For the most part, however, as the dot-com bust slips farther into the past, it is also slipping further from investors' consciousness. "The trend is that as every month goes by that tech continues to do well, and as the terrible memories of 2000 through 2002 fade farther into the distance, your traditional institutional money mangers are continuing to wade back into the sector," says Whitney Tilson, founder and managing partner of N.Y.-based Tilson Capital Partners LLC. "Most people manage money with their eyes firmly affixed to the rear-view mirror, and that trend will continue--until it doesn't."

A 'Little ' Something Extra

On the bleeding edge of technology is nanotechnology--the manipulation of atoms and molecules on a microscopic scale. With a broad range of uses, many high profile companies such as GE and IBM have been investing in this area and have attracted widespread investor interest. According to Jack Uldrich, president of The NanoVeritas Group, a consulting firm focused on nanotechnology, and author of Investing in Nanotechnology, there are currently more than 100 nanotechnology companies, roughly 60 of which are publicly traded. "Even if you don't invest in nanotechnology, you have to be aware of it," says Uldrich, adding that these companies could have a major impact on existing business. For example, he notes that nanotechnology companies have begun successfully growing two-carat diamonds at a rapid pace for less than $10 each. "Today, diamonds are still fairly expensive commodities, and we mine them. But pretty soon we're going to be growing them in strip malls overnight," Uldrich says.

Britt Erica Tunick is a writer who specializes in financial topics.

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