Nascent recovery in IT funds: Invest systematically, hold for long term

Experts suggest holding them for long term, say tech stocks may take a hit if economic conditions in US or Europe worsen

After prolonged stagnation, technology sector funds now appear to be in recovery mode, in tandem with the global markets. The active (direct) plans of these funds have given a category average return of 5.4 per cent year-to-date, surpassing the 2.7 per cent return of the Nifty50 and the 1.5 per cent return of the Nifty IT index. Altogether 16 (active and passive) funds in this category manage assets worth Rs 25,796 crore (April 30, 2023).

Promising in the long term

Experts say the long-term outlook for the Indian information technology (IT) sector remains promising, notwithstanding the near-term headwinds. Says Vaibhav Dusad, fund manager, ICICI Prudential Mutual Fund, “Over the past years, Indian IT companies have transformed themselves to cater to the demands arising in the new digital era. A technology upgrade cycle, which started during the pandemic, is underway and is expected to last for the next four-five years.”

The sector has several inherent strengths. Says Arvind A Rao, founder, Arvind Rao and Associates, “The solid financial profile and strong balance sheets of companies within the sector will help them generate free operating cash flows. A stable employee turnover rate and increased focus on training should help manage manpower costs. A depreciating rupee will enhance the realisation from export earnings.”

Key growth drivers

Indian IT companies stand to benefit over the medium term from the major trends in technology shaping up globally. Says Dusad: “Automation, big data analytics, and cloud-native application development will constitute the core components of growth. Cloud migration and penetration will remain a key driver for the next few years.”

Watch out for recession impact

Indian IT companies, which derive a major part of their revenue from mature markets like the US and Europe, may face headwinds if these economies witness a major slowdown or recession due to the rapid hike in interest rates over the past year. The faltering of banks in the US and Europe could also impact the earnings of Indian IT companies.

Says Alekh Yadav, head of investment products, Sanctum Wealth: “A potential global recession, led by the US, is a significant concern for the IT sector. This concern was reflected in the outlook shared by the management of these companies while announcing their Q4 FY23 earnings. If the US economy enters a recession, the demand outlook for Indian IT companies may dampen.”

Accelerated development in areas like artificial intelligence (AI) could also pose a challenge to Indian IT companies.

Concentration risk

Technology funds invest at least 80 per cent of their corpus in IT sector stocks. When the sector falls out of favour, the managers of these funds don’t have the option to switch to other sectors, as those managing diversified equity funds can. “Owing to high concentration risk, both the rewards and the losses tend to be high in these funds,” says Rao.

Investors also face timing risk in thematic funds. Says Yadav: “Investors need to time both their entry and exit accurately. Most may not be able to pull this off successfully.”

Should you invest?

Novice investors should avoid sector-specific funds like tech funds. Flexi-cap funds, on average, have 9.1 per cent exposure to tech stocks. Investors who hold these funds would have adequate exposure to the sector and hence need not invest directly in tech funds.

Investors who have a positive long-term view of the technology sector, and want to benefit from the recent correction, may invest in these funds. Says Dusad: “Enter these funds with a two-four-year perspective. There could be volatility in the near term, therefore invest through systematic investment plans. Do a lump sum only in case of a sharp correction in the sector.”

Rao adds that investors considering these funds should have a long investment horizon and large risk appetite, and should not expect quick returns.

Yadav says exposure to thematic funds, including tech funds, should not exceed 10 per cent of the portfolio.