Tech sell-off: what’s going on and key questions for fund investors

The AI trade that has dominated markets for the past two years is facing its biggest test yet.

Last week, the Nasdaq Composite index entered correction territory having declined more than 10% from the record high level achieved last month. 

Both the Nasdaq and S&P 500 eked out a positive session before the weekend (6 November), but over one month are showing losses of 10.2% and 5.6%. 

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For some time, one of the biggest debates occupying investors has been whether the enormous sums being spent on AI infrastructure and development will ultimately generate the future earnings growth and profits the market is expecting.

As Ben Whitmore, manager of the TM Brickwood Global Value and TM Brickwood UK Value funds, pointed out when he appeared on our On The Money podcast in August, the scale of AI-related investment is remarkable by historical standards.

He said: “It has exceeded cars and railways and all the other things that have transformed people’s lives. The scale of the investment is exceptionally high in relation to history.

“We don’t know the answers to the returns on AI investment, but what we do know is that on average, low valuation is where we want to concentrate, not high valuation.”

Concerns over AI spending were already beginning to build before the latest bout of market weakness.

However, the sell-off has been exacerbated by concerns that Democratic gains in the US midterm elections could lead to stricter regulation of data-centre development. If projects face delays or additional hurdles, the pace of the AI infrastructure expansion could slow.

Richard Hunter, head of markets at interactive investor, says: “The Democrats’ newfound power following the election success followed a campaign largely predicated on the populist AI backlash. Most notably, data-centre development came under fire which, if implemented, could put the brakes on the AI surge, not least through reduced chip demand. This latest jolt followed what had already been a jittery space, with concerns over whether the returns on the huge AI spend could or would be sufficiently met.”

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Matthew Quaife, global head of multi asset at Fidelity International, notes that Democratic victories in key states such as Texas, Ohio and Georgia have raised concerns over greater restrictions on data-centre development. He says there is the prospect of “tighter permitting requirements and potential construction delays”.

To summarise, if data-centre construction slows, demand for semiconductors and other AI-related infrastructure may also grow more slowly than previously expected. Given that investors have been pricing in years of rapid growth for companies supplying the AI ecosystem, this has led to heightened volatility.

Moreover, the prospect of delays to data-centre development mean big tech names that have spent big on AI infrastructure will have to wait longer to see if their investment pays off.

There’s been some notable declines, with poster AI child Nvidia (NASDAQ:NVDA) down 8.4% over the past week, while Vertiv (NYSE:VRT), Broadcom (NASDAQ:AVGO) and Advanced Micro Devices (NASDAQ:AMD) have given up 15.8%, 10.2% and 7.9%.

Investors in technology funds have suffered similar losses, with funds such as Liontrust Global Technology and AXA Framlington Global Technology down around 10% over the past week. 

For investment trusts, tech duo Polar Capital Technology (LSE: PCT) and Allianz Technology (LSE: ATT) are down 7.8% and 7.4%.

Guy Thornewill, direct equities director at Canaccord Wealth, says the market “has taken a typical ‘shoot first, ask questions later’ view, and aggressively sold off those companies providing equipment for data centres, or the chips that go into them”.

Tech teething problems

So, what next for tech? The consensus view is that there is no fundamental change to the AI investment case. While the roll-out of data centres may slow, it is unlikely to come to an abrupt halt.

Quaife notes that: “AI remains transformative, with the potential to reshape how we work and live, while driving meaningful change across industries.”

However, he adds that the opportunity set is potentially changing, predicting that “the next phase of the investment cycle will increasingly favour higher-quality companies with easier access to financing, while opportunities broaden towards companies adopting AI rather than those focused purely on capital expenditure”.

Thornewill leans more towards “buying the dip”. He observes: “Demand for AI tokens remains very high, which is a key component for the health of the AI build-out, and a more rational level of capex would lead to a better outcome for many companies.

“We expect the sell-off to throw up some selective buying opportunities in technology stocks and those companies related to the AI infrastructure build-out. However, in the short term we would expect volatility to continue as investors digest this latest development.”

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However, other investors are sceptical and concerned that AI-related stocks are a classic investment bubble of valuations racing ahead of reality.

In a recent On The Money podcast episode, fund manager Nick Clay, who manages TM Redwheel Global Equity Income, made the point that despite some of the big tech giants being great businesses, if valuations are “wrong” they “become the riskiest businesses in the world”.

He added: “All the valuation of a company is, is the expectations placed upon it of what it has to deliver. So, if your valuations are incredibly high, then what you have to deliver has to be exceptional all the time. That’s difficult to do for any company, however good you are. So, your risk is very high because you’ve only got to stumble a little bit and everybody panics.” 

Implications for fund investors

Technology investors have enjoyed an extraordinary run over the past couple of years. Whether you backed the Magnificent Seven, owned a technology fund or investment trust, or simply gained exposure through a global index fund or exchange-traded fund (ETF), there’s a good chance those holdings now make up a much larger proportion of your portfolio than they did originally. As we recently explained ahead of the sell-off, rebalancing is a useful method to reduce risk.

It is also worth remembering that many investors have more technology exposure than they realise. Even those who do not own a dedicated tech fund can have significant exposure through global equity funds, US equity funds and tracker funds that follow indices such as the S&P 500 or MSCI World.

This has led to increased levels of concentration risk. The so-called Magnificent Seven account for around a third of the S&P 500 and over a fifth of the MSCI World.

Investors concerned about concentration risk could consider equal-weighted index funds or ETFs, global funds that strip out US exposure or global funds that are light on US equities. All those approaches were discussed in our recent On The Money podcast episode.

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Concentration risk isn’t confined to the US. In the Asia-Pacific region, companies such as Taiwan Semiconductor Manufacturing Co Ltd ADR (NYSE:TSM), Samsung Electronics Co Ltd DR (LSE:SMSN) and SK hynix Inc ADR (NASDAQ:SKHY) account for a significant share of index returns. As a result, the region has become more dependent on the fortunes of this trio of semiconductor giants. 

This has been evident over the past week as Korea-focused funds have been the worst performers, with Barings Korea I GBP Acc (B9M3RQ4) and iShares MSCI Korea ETF USD Dist GBP (LSE:IKOR) racking up losses of over 4%.

For long-term investors, the key question is not whether technology shares can fall sharply, but whether the long-term investment case for AI remains intact. 

For now, most professional investors believe it does, albeit with greater uncertainty over the path ahead.