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Why It Doesn't Pay to Buy Tech's Big Boys

This column was originally published on RealMoney on Sept. 20 at 2:11 p.m. EST. It's being republished as a bonus for readers.

It could be argued that it makes no sense to take on single-stock risk if the stock in question can't beat its sector index. A case in point would be the technology sector.

In the last three years, investors have not been rewarded for the extra risk taken by owning individual large-cap tech stocks, particularly the largest.

The chart below compares the biggest Nasdaq tech stocks, along with IBM (IBM - Get Report), to the iShares Dow Jones U.S. Technology Sector Index Fund (IYW).

All of the stocks charted are what are referred to as mega-cap stocks -- companies greater than $100 billion in market cap (Dell used to be at $100 billion, but it's now back down to $82 billion). There are 18 companies in the S&P 500 with a cap greater than $100 billion. Of them, 13 have lagged their respective sectors over the last three years. None of the five that beat their sector was a tech stock.

All parts of the market have their day in the sun; for mega-caps, that day was during the late 1990s. Since then, small-cap has outperformed large-cap.

There is some market history behind this idea: large-cap typically outperforms as a bull market matures. Admittedly, the last few years have been unusual as small-cap has led, yet we still may have a bear market sooner, rather than later, as the current cyclical bull is long by historical standards.

At some point in the future, mega-caps will provide leadership and it will make sense for the average cap size of a diversified portfolio to be larger than the average of the S&P 500, which is $90 billion. So at some point taking single-stock risk in this part of the market will be rewarded, but I do not see any immediate visibility for this now.

If this line of thinking makes sense to you, one of the tech sector ETFs would make a good proxy for the group. Again, the idea here is that if stock selection in the bigger caps will likely result in returns that only match the sector, the potential reward does not justify the risk taken.

The Big Names in Tech vs. the Sector
Over the past three years, Microsoft, Intel, Cisco and Dell have trailed their sector, as represented here by ETF IYW.

This strategy lends itself well to areas of the market that don't usually pay high dividends, like technology or small-caps. If a stock provides sector-matching price appreciation with triple the dividend of a sector fund, owning the stock may make more sense. Most tech stocks have very little or no dividends, so the focus becomes mostly about expected price appreciation in a stock vs. the rest of the sector.

In blending together the tech portion of a portfolio, it makes sense to have exposure to different cap sizes and different parts of the sector. For example, eBay (EBAY) would not necessarily correlate that closely to F5 Networks (FFIV), but they are both tech stocks.

F5 Networks and eBay

Neither correlates highly with IYW. If the technology portion of a portfolio was 70% IYW (or any other broad-tech ETF), 15% EBAY and 15% FFIV, diversity would be captured within the sector. Furthermore, there would be the chance for outsized gains from two different stocks that depend on completely different types of demand. eBay and FFIV are just examples; there are plenty of other tech names that give a chance of beating the sector.

Seventy percent of the sector in one broad ETF might seem high, but how many people do you think own Cisco Systems (CSCO - Get Report), Microsoft (MSFT - Get Report) and Intel (INTC - Get Report) as 70% of their tech holdings?

There are six broad-based tech ETFs: the aforementioned iShares Dow Jones U.S. Technology, iShares Goldman Sachs Technology Index (IGM), iShares S&P Global Technology Sector Index Fund (IXN), streetTRACKS Morgan Stanley Technology Index Fund (MTK), Technology Select Sector SPDR Fund (XLK), Vanguard Information Technology VIPERs (VGT).

Tech ETFs

While all of them have a reasonable correlation to each other, MTK has been a clear outperformer, thanks to its heavy weight in Google (GOOG) and, to a lesser extent, Texas Instruments (TXN) and Broadcom (BRCM).

The idea here is that single-stock risk is taken out of the portfolio in the area that may not give an opportunity to outperform, but single-stock risk is left in names that might.

Blending different products together can be a great way to build a portfolio.

P.S. from Editor-in-Chief, Dave Morrow:
It's always been my opinion that it pays to have more -- not fewer -- expert market views and analyses when you're making investing or trading decisions. That's why I recommend you take advantage of our free trial offer to RealMoney premium Web site, where you'll get in-depth commentary and money-making strategies from over 50 Wall Street pros, including Jim Cramer. Take my advice -- try it now.
At the time of publication, Nusbaum was long iShares Dow US Tech, Dell and Google in client accounts, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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