Managing Concentration Risk in a Portfolio’s Tech Allocation

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Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Robertson Velez, portfolio manager at CIBC Asset Management. I run the CIBC Global Technology Fund.  

The technology sector has had a very strong run, a significantly higher return over the broader benchmark, and this has been driven mostly by the outperformance of the largest capitalization tech stocks, The Magnificent Seven.  

So, there are two main reasons for this outperformance. One is just the renormalization of business post the huge disruptions caused by the pandemic. So, coming off the bottom in 2022 the high operating leverage from scale of these Mag Seven names drove faster EPS growth in the recovery. And because these companies had very strong balance sheets, they were much less negatively impacted by rising interest rates.  

The second reason is generative AI. Over the past two years, we have seen massive CapEx investments by hyperscalers in this new technology, which many think is a technological revolution on the same scale as the internet or the smartphones.  

How do tech stocks fit into a 60/40 portfolio? Well, I’d like to share a view that may not be the same as mainstream views on how tech stocks fit into the 60/40 portfolio. The 60/40 portfolio is meant to enforce a framework for diversification between equity and fixed income. In that respect, it’s a useful tool, but within the equity portfolio, it is still important to get the best risk adjusted return, which is what technology sectors represent today.  

Technology is already a large sector weight in most broad-based equity indexes, making up roughly 30% of the S&P500. My argument is that if most of the returns are generated by these stocks that are focused on innovation, why not increase the exposure to the higher growth sectors?  

So, over the past decade, the technology sector has significantly outperformed the broader market, even including the down years. The downside, of course, is that higher returns come with higher volatility. So, there is a tradeoff between returns and volatility that every investor will have to make based on their own risk tolerance. 

So, the opportunities that exist in tech generally revolve around new technology segments. So, right now, about 70 to 80% of the current technology portfolio is in some way related to the theme of generative artificial intelligence. This is not so much by design, but given this transformational shift in the industry, this is the major theme that many of these quality companies are finding opportunities in.  

By now, everyone’s probably heard of Gen AI and tried some form of ChatGPT. In my view, many of these applications are novel and interesting, but barely scratched the surface of the potential for Gen AI. Today, we are generating over 300 million terabytes of data per day globally. This data has incredible value, but most of it is in an unstructured form and remains inaccessible to us. Generative AI represents the best tool we have to date to be able to extract meaning from all this data.  

With generative AI, large language models can be trained to understand this data and explain it to us in plain English or whatever language we choose, and turn this mountain of data stored by large enterprise into something useful, which more than any other technology has the potential to drive massive gains in productivity and transform industries.  

So now, let me try to weave this generative AI theme into a cohesive set of opportunities in our portfolio. Nvidia is the clear leader in generative AI because this technology is a de-facto standard in implementing AI solutions, due not only to its superior hardware roadmap, but the stickiness of its software infrastructure solutions. The question I’m most often asked about Nvidia is whether, after the spectacular run we’ve seen over the past couple of years, is there still room enough to go?  

In terms of the next week, next month or next quarter, I don’t know, but if we are talking about the long term, I’d like to provide some perspective. There is a total installed base of $1 trillion in traditional data centre infrastructure globally, of which Nvidia’s accelerated computing infrastructure is a small but growing part. I would estimate less than 10%. So, this is the opportunity ahead, and as AI becomes table stakes for businesses to remain competitive, data centers will need massive incremental improvements through accelerated computing to keep up.  

Beyond Nvidia, I invest in the semiconductor infrastructure that enables AI such as ASML for semiconductor production tools or complementary technology companies, such as Broadcom for connectivity.  

And the biggest long-term opportunity for Gen AI is in software that helps enterprise use AI to access its troves of data. Microsoft is the obvious leader here with its partnership with OpenAI. Other software vendors that can benefit from AI are those that can integrate AI tools with customer data, such as ServiceNow or Salesforce.  

And then finally, there are consumer platforms that can significantly leverage AI, such as Apple, Alphabet, Meta, all at various stages of development, but all with massive potential to deploy Gen AI at scale. And so, that’s how we’ve been positioning the portfolio to take advantage of this opportunity. 

The challenge ahead for investors, I think, is in stock selection rather than sector selection. There is a perception that tech has massively outperformed other sectors over the past two years, but I think this is not entirely accurate. The large-cap tech stocks that we refer to as the Mag Seven have massively outperformed, but the rest of the tech sector has had relatively muted returns, similar to other sectors, so there is still significant room for outperformance. I think what we will see is that performance will broaden up beyond just the Mag Seven as we start to see higher earnings growth for other tech names. Although, I think the highest quality names will still continue to outperform.  

The challenge is not just in choosing which of the tech stocks to invest in, but to have a conviction to invest enough in the right names to make a difference. In the portfolio we remain concentrated in the highest quality names, but we are broadening out to find opportunities in smaller-cap names, such as, for example, Trade Desk and Shopify.  

I think the important question to ask is not so much which sectors will outperform, but rather which stocks within each sector will outperform, including tech. And we have to become increasingly more selective in our process of picking winners and losers as technology such as Gen AI continue to evolve.  

Should investors be concerned about over concentration in the sector? In terms of whether I think investors should be concerned about overconcentration, I want to share a view that may be different than conventional thinking. So, I’ll caveat this by saying that investor clients need to be aware of their own risk tolerance to decide what strategy works for them.  

But in my view, diversification is generally desirable to the extent that you can lower the risk in the portfolio for the same level of return or better. So, this is kind of free lunch that is offered by diversification. However, this is not the case when you are comparing different levels of risk and return. So, in my view, it is generally better to concentrate your portfolio if you can achieve a better risk adjusted return, where you are compensated for the higher risk by a disproportionately higher return or a potential return. And this is what investing in technology and innovation promises.  

That being said, I do acknowledge that there is a certain cyclicality to tech investing, in that these cycles typically last a decade or more, roughly in line with the economic cycle and the adoption of new technologies. So, I take that into account in my investment thinking. It’s usually very difficult to know exactly where we are in the cycle at any given time, but you can tell in hindsight where the bottoms of those cycles were. We had a bottom in the tech bubble of 2000, in the Great Financial Crisis of 2008 and the Covid renormalization in 2022, so my opinion of where we are is that we have just come off the bottom in this tech cycle, we have a long runway of growth ahead, with new technologies such as Gen AI still continuing to prove its potential.  

That being said, I do expect significant volatility along the way, as tech has always had a higher level of volatility, and this is part of the opportunity to generate outsized returns, and is what we are here to manage. So obviously, I am 100% concentrated in tech, and so in my view, it’s not so much about over concentration in tech, but about managing the risk in that concentration and achieving better returns.