Technology funds. These mere words evoke strong memories for some investors, from the euphoria during the off-the-charts growth of the late 1990s to widespread despair during the subsequent tech meltdown between 2000 and 2002.

Technology is such an integral part of all aspects of our daily lives that the sector is virtually certain to have more days in the sun. Despite this, many investors still look with great suspicion at mutual funds that concentrate in this sector, wondering if the bottom might fall out on them again. This article will examine the nature and composition of technology funds, as well as how they performed both before and after the market downturn in 2000.

Technology Fund Basics
Virtually all technology funds are stock or equities-only funds and the majority of them fall into the growth fund category in the Morningstar style box. These funds will invest in a wide range of technology-related companies, including anything associated with the research, development and use of computers, software, communications, the Internet, semiconductors or any other segment of technology. Biotechnology funds are usually included in the healthcare sector, although they can sometimes fall into the tech sector as well. As with most other types of funds, tech funds can also be either domestic or global in regards to what securities are eligible for purchase.

SEE: Understanding The Style Box

Although there are exceptions, most technology funds tend to seek companies that fall into one of two categories. The first category is comprised of larger, more established technology companies that have strong cash flow and substantial market share. The second category contains companies (usually smaller ones) that have developed new ideas or patents that analysts believe will provide significant potential for growth. The volatility inherent in this sector often results in high portfolio turnover, which is usually greater than that of funds in other sectors, such as energy or consumer staples.

Technology Fund Performance
The tech sector is a relatively new corner of the market, and did not come into its own until the 1990s. As mentioned in the introduction, technology funds had their heyday in the late 1990s, when many of them reaped enormous gains from 1996-1999, and then flamed out spectacularly in the following years. Some funds posted astronomical losses, while others, such as the Alliance Technology fund, became embroiled in the accounting scandals that went hand-in-hand with the market decline.

Technology funds also tend to be volatile, although their price movements have historically been relatively tangential to the overall markets. When the broader market rises, the tech funds will often appreciate sharply; the same thing applies in reverse in bear markets. Several different benchmark indexes have been created in the tech sector in recent years, such as the S&P North American Technology Sector Index and the Goldman Sachs Technology Sector Index.

SEE: Benchmark Your Returns with Indexes

Why Would I Invest in a Tech Fund?
In terms of investment objectives, technology funds serve only one purpose: growth. Even value investors should stay away from this sector, as it is not mature enough to offer significant holdings in this style box category. Technology funds are also clearly not appropriate for conservative investors or those seeking income. Tax-conscious investors should also carefully consider the capital gains distributions that will result from high portfolio turnover However, those investors who are seeking long-term, aggressive growth holdings for their portfolios would be wise to consider a fund in this category.

The market bubble that these funds floated on from 1996-1999 has long since burst and fund prices have rested on much more fundamental support since that time. Capital gains-conscious investors may also want to consider a unit investment trust (UIT) that invests in the tech sector. Exchange-traded funds (ETFs) that invest exclusively in technology are also available for day traders.

The Good, the Bad and the Ugly
Investors must consider the same criteria when examining technology funds as those of any other sector. However, the performance figures for technology funds must sometimes be interpreted somewhat differently than for other sectors. This applies primarily to beta and other quantifications of volatility. For example, a beta of 1.5 may be excellent for a tech fund, especially one that invests in a subsector of technology, such as biotechnology. Past performance should also be looked at in light of what the tech sector has done, as well as the overall market. A tech fund that has dropped 15% over a given period of time may still be a good long-term buy if the average tech fund has dropped 30% over a similar term. As with all other sectors, the most well-known funds are not necessarily the best ones.

The Bottom Line
Technology investors have endured a wild ride over the past several years and this pattern will likely continue over time. The volatility and capital gains distributions inherent in these funds should be carefully weighed against their performance history as well as the objective and risk tolerance of the investor.

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