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Investing in the diverse and rapidly growing technology sector can be rewarding. It also can be risky. Your role as a financial advisor is to help clients make the best possible investment decisions when seeking to take advantage of opportunities in this growing sector.

Technology stocks are regarded as a major driver of change in the global economy. They include shares of both established and smaller “young” companies.

From a sector standpoint, technology stocks are classified as either “information technology” (IT), which includes stocks such as Apple Inc. and Microsoft Corp.; or “communication services,” which includes stocks such as Alphabet Inc. (a.k.a. Google) and Facebook Inc. Together, the two classes comprised slightly more than one-third of the weight of the S&P 500 composite index as of Dec. 31, 2019.

Tech behemoth Amazon.com Inc., however, is classified under the “consumer discretionary” sector, according to the Global Industry Classification Standard (GICS), thus demonstrating the challenges inherent in using a GICS sector-based approach.

In the technology-light Canadian market, clients must turn to the communication services and IT sectors, which together comprised slightly less than 14% of the weight of the S&P/TSX composite index as of Dec. 31. The former sector includes companies such as BCE Inc. and TELUS Corp., while the latter sector includes Shopify Inc. and Constellation Software Inc.

When your clients decide to invest in technology, they must be aware that the tech category is undergoing massive transformation, resulting in changing investment opportunities.

“Many of the biggest ideas in technology over the past decade have centred on how people communicate, consume, transact and travel,” states a report from New York-based Morgan Stanley entitled The Second Machine Age Hits The Tipping Point. “Over the next decade, however, the most profound innovations β€” and investment opportunities β€” could be on factory floors, in operating rooms, at mining sites and energy facilities.”

As technology investments shift from the consumer to the enterprise world, the focus will be on six developing technologies: artificial intelligence (AI) software, autonomous vehicles, the internet of things (IoT) hardware, industrial software, robotics and semiconductors. The market for these technologies combined, according to the Morgan Stanley report, could see annual growth of 17%, rising from US$738 billion in 2018 to US$2.2 trillion by 2025. The report predicts the highest growth will come from AI software (42%), autonomous vehicles (40%) and IoT hardware (21%).

“There are so many great ways to make money in technology, but also many ways to lose money,” cautions Marcello Montanari, vice president, senior portfolio manager, North American equities, and co-manager of RBC Global Technology Fund along with Rob Cavallo, analyst and portfolio manager on the same team at RBC Global Asset Management Inc. in Toronto. “The benefit of being right can be quite lucrative,” says Montanari. “But the price of being wrong can be costly.”

Individual investors will “need to know what they are buying and stick to things that they understand,” Montanari advises.

Elliot Johnson, chief investment officer and chief operating officer with Evolve Funds Group Inc. in Toronto, says, “Tech investors face a choice between individual stock selection and using a fund product” such as a technology-based mutual fund or ETF.

Johnson says that while “some well-known tech stocks have delivered market-beating returns, the challenge is how to select the best one at the right time.” He also cautions that “tech stocks can be volatile and you can just as easily pick a loser as a winner.”

Johnson recommends a diversified ETF-based approach: “It is easier to see the development of a theme than to pick a single winning company. An index approach to investing in tech is more likely to succeed than buying one or two stocks.”

For example, Johnson says, investors looking for exposure to automotive innovation could buy stock in Tesla Inc. or an ETF that invests in the technologies involved in electrification and autonomous driving.

Evolve offers several technology-specific ETFs that enable unitholders to take advantage of technology trends, such as Evolve Cyber Security Index ETF, which invests in companies involved in digital security, and Evolve E-Gaming Index ETF, which invests in leading video-game companies.

There are many other technology-based ETFs, including iShares S&P/TSX Capped Information Technology Index ETF, which provides targeted exposure to Canadian IT companies; TD Global Technology Leaders Index ETF, which tracks global mid- and large-capitalization technology stocks; and Horizons Robotics and Automation Index ETF, which provides exposure to companies involved in the development of robotics and AI.

Montanari, on the other hand, says that investing in an index-based ETF is akin to “buying a blind pool of stocks.” He invests primarily in larger companies and avoids startups, which, he says, have “an abysmal track record, with 99% of these companies never amounting to anything.”

Johnson advises caution regarding nascent firms: “Some people believe you make your best returns from getting in early on startup companies. While it is certainly the case that founders can make outsized returns, they also take on outsized risks, which they manage by being in control of their businesses.”

When investing in smaller companies, Johnson says, “the best way to manage risks is to run a diversified portfolio so that the few winners can offset the many losers.” That’s a labour-intensive process and difficult for the average investor to manage. But, he adds, “The problem with large-cap tech investing is that you tend to be overexposed to giants such as Apple, Facebook, Amazon, Alphabet and Microsoft.”

These companies, Johnson says, often invest in smaller tech innovations, but their share prices are unlikely to reflect their success in new business categories. “Alphabet has spent a great deal of money on self-driving car technologies,” he says, “but those innovations are not reflected in their share price because they are an online advertising company.”

Konrad Kopacz, partner and portfolio manager with Echelon Wealth Partners Inc. in Oakville, Ont., invests in individual stocks with about an 80% weighting to market leaders in their respective space, as well as in ETFs. The remaining 20% of his clients’ holdings are in “younger, smaller companies that could have the potential for explosive growth, but must have a clear path to profitability.”

Kopacz says market leaders typically are more likely to be profitable, generate stronger cash flows, have “higher barriers to entry” in their respective spaces and have a better chance to withstand volatility or a market correction. Those companies also have the ability to “buy out” smaller companies entering the domain of the market leaders or that have complementary technology platforms.

“Most smaller companies have an aggressive plan for growth,” Kopacz says, “but actually meeting those targets is another question altogether.”

When Kopacz recommends technology stocks to his clients, he spends time educating his clients about what the future holds for each company and the associated risks.