How to buy the NASDAQ to grow and diversify

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It is said that the one ‘free lunch’ in investing is diversification. By holding a number of investments with lowly correlated returns, investors may be able to achieve decent rates of portfolio return while reducing volatility.

And in terms of global markets, one area where the Australian stock market is relatively under represented is in technology. The information technology sector, for example, comprises less than 1% of the S&P/ASX200 index – whereas it accounts for around 20% of the United States S&P 500.

Strong performance

That’s especially a shame because since the bursting of the dotcom bubble earlier last decade, the IT sector has been one of the star performers of the US market. The tech-heavy NASDAQ 100 index, for example, has consistently outperformed the S&P 500 since mid-2002 – and especially since 2006.

More recently, the NASDAQ has outperformed the S&P 500 in each of the past three years, and it’s on track to outperform it again in 2012. It has also left the Australian market for dead, outperforming us by around 20 percentage points in each of the three years from 2009 to 2011. So far this year, the NASDAQ is up another 20%, compared with the 11% gain for the S&P/ASX200.

Currency diversification

The other benefit of America’s technology sector is that that US dollar currency exposure (assuming an unhedged investment) provides another level of diversification.

Since 2003, the standard deviation in annual returns for the NASDAQ in US dollar terms has been 23%, though only 13% in Australian dollar terms. That compares favourably with a standard deviation in annual price returns for the S&P/ASX200 of 22% over this period. Of course, the NASDAQ has been less volatile in Australian dollar terms in recent years largely because of its US-dollar gains have been dampened by the rising Aussie.

That said, the correlation in annual returns between the NASDAQ and local market has been relatively high at 85% – consistent with the “risk-on risk-off trade” nature of global trading in recent years. But while both tend to rise and fall together, their relative performance is driven by quite separate factors; for the NASDAQ, it is technological innovation and adoption, whereas our market is largely tied to the financials sector and resources (that is, China).

Tech sector outlook

If resource prices continue to fall – and along with them, the Aussie dollar – it may well be the case that the drivers of America’s tech sector will continue unabated. In this sense, the tech sector provides a handy hedge – and source of diversification – for resource exposed Australian investors.

Note, moreover, the US tech sector appears far from over valued. The price to forward earnings ratio has averaged around 13 since mid-2008, and is currently around 12. That’s a far cry from the price to earnings (PE) of 40 to 50 during the dotcom bubble, and it’s attractive for a sector that has posted annual growth in forward earnings of around 20% in the past three years.

According to Thomson Reuters estimates, analysts expect earnings for the US technology sector to grow by around 12% this year, and 13% next year. Earnings expectations have held up fairly well through the year so far.

What to buy

Perhaps the easiest way to gain access to this sector is through a US-listed ETF through your broker, such as State Street’s S&P Technology Sector ETF (NYSE code XLK). The top tech holdings for this ETF are currently Apple (20%), IBM (7.6%), Microsoft (7.5%), AT&T (7%) and Google (6.7%).

Note moreover that these ‘cap weighted’ ETFs effectively cut losing stocks and replace them with ‘up and comers’ over time. Stock that fail to perform lose market value and are eventually dropped from the major indices tracked by the ETF – while newer stocks rising in market value (such as Google of late) eventually enter these major indices.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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