Bet on IT funds to gain from digitisation, generative AI adoption

Limit allocation to 10% of equity portfolio and enter with a five to seven-year horizon

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Technology funds are the worst-performing equity fund category over the past three months, declining 10.2 per cent. While they are up 25.9 per cent over the past year (according to Morningstar.com data), they are laggards compared to other sectors even over this horizon. Fund managers, however, believe the prospects of these funds remain sound over the medium to long term.  

Recovery may be delayed

Companies spent far above average on technology during Covid-19, boosting the earnings of technology companies. Spending has been normalising since then. “The rationalisation of technology spending growth to more normalised levels is affecting tech companies’ earnings,” says Trideep Bhattacharya, chief investment officer-equities, Edelweiss Mutual Fund.

Global macroeconomic concerns arose in January 2022. “A recessionary outlook developed in the United States (US), which accounts for 40-50 per cent of global IT spend. US companies have tightened their purse strings,” says Meeta Shetty, fund manager, Tata Asset Management.

The S&P BSE IT index has corrected 12.3 per cent over the past three months as tech companies’ revenue growth faltered in both the third and the fourth quarter of 2023-24 (FY24). Shetty says the derailment of recovery hopes was responsible for this correction.

“Growth recovery expectations have been pushed ahead by three to four quarters to FY26. There has been some moderation in margin expectations as well,” says Vaibhav Dusad, fund manager, ICICI Prudential Asset Management Company.

Overall demand has been weak globally. “The financial services sector in the US and Europe is in pain due to high interest rates and high mortgage rates. Earnings of this sector, a major spender on technology, have been weak,” says Bhattacharya.

Rate cuts could drive recovery

A turnaround in the tech sector is closely linked to interest rate cuts and an economic recovery in the US. Rate cuts have got postponed to October-November and could get further delayed to the next calendar year. “Whenever we have visibility on the start of the rate cut cycle, that could be a lead indicator of improvement in IT spends,” says Shetty.

Fund managers remain optimistic about the sector’s medium to long-term prospects. “With the world moving towards the digital format, companies must digitise, which makes IT spending a compulsion. Hence, we are positive on IT spends coming back over a two to three-year period,” says Shetty.

The adoption of generative artificial intelligence (Gen AI) is also expected to provide an impetus to growth. “Although Gen AI will have some cannibalisation impact, it will also lead to new spending by clients, once its broader adoption begins in a couple of years,” says Shetty.

Dusad expects a gradual growth recovery from Q4FY25 onwards, once the US elections end, and potential acceleration from FY26.

A high-quality sector

The IT sector has many inherent strengths. “Companies have strong balance sheets and follow good corporate governance practices. They generate healthy free cash flows and pay high dividends. All these attributes make it a relatively high-quality sector,” says Dusad. He adds that the sector is also insulated from potential risks to the domestic economy.

Should you invest?

Sector valuations are in a neutral to mildly attractive zone, according to Dushad. Shetty is of the view that investors who wish to benefit from the trend towards digitisation and Gen AI adoption should have an allocation to this sector.

Do not, however, enter expecting quick returns. “Investors should adopt the systematic transfer plan (STP) mode to gradually increase exposure over the next six to nine months,” says Bhattacharya.

A sector fund is not diversified across sectors and hence is prone to high volatility in tandem with the sector’s business cycle. “If one is not nimble, allocation to a sector fund could soon turn sour,” says Abhishek Kumar, a Sebi-registered investment advisor (RIA) and founder, SahajMoney. He believes most investors would be better off investing in a diversified fund instead of trying to time their entry and exit strategy in these funds.

“But if you wish to invest, then limit your allocation to a sector fund to 10 per cent of the equity portfolio and invest with a five-seven-year horizon to smoothen out returns over cycles,” says Kumar.