The information technology sector has often been in the news in recent times, backed by a strong performance in the fiscal year 2006-07 -- both in terms of earnings results (as seen in Infosys recently) and the concomitant stock market rally.

The BSE IT index has clocked a growth rate of 31.9%, against the Sensex which gained 21.7% in the last one year. As has been the case historically, the IT sector has shown higher volatility in returns � the IT index has an annualised standard deviation of 32.0%, compared to 24.0% of the Sensex.

Going forward, however, while we think that the IT sector is largely insulated from the effect of the recent interest rate hikes, two large clouds appear over the horizon -- viz. the rapidly appreciating Rupee and the slowdown in the US economy.

Unlike in the previous fiscal year, the Reserve Bank of India has been reluctant to continue intervening in the foreign exchange market to keep the Rupee low (ostensibly fearing further liquidity release into an already high inflation scenario domestically).

If this Rupee appreciation continues, we expect a hit on IT industry profitability even if the bigger companies hedge a substantial portion of their foreign exchange receivables.

The slowdown of the US economy is expected to have a mixed impact. On the one hand, it is already mitigated by IT majors looking at Japan and Europe in a bigger way. Moreover, a slowdown is expected to simultaneously increase pressure to cut costs and hence offshore activities in a bigger way.

In summary, the coming year does not look as rosy for the IT sector as the previous one. However, we expect the IT industry to provide good returns over a 3-5 year time frame.

Investing in the IT sector

Should you, as an investor, desire to invest in the IT sector, we recommend the mutual fund route. For larger companies, an analysis of the extent of foreign exchange hedging and diversification across developed markets is important; while smaller company stocks move significantly on success in bagging large individual contracts (as, for example, Tech Mahindra did last year) and can thus have high volatility.

The pros and cons of mutual funds vis-�-vis direct share investments have already been elucidated in articles earlier. In the rest of this article we briefly analyse and compare different IT sector funds present in the market.

Sector Fund Performance

There are eight major IT sector funds today:

• DSPML Technology Fund
• UTI Growth Sectors Fund -- Software
• SBI Magnum IT Fund
• Kotak Tech Fund
• Franklin Infotech Fund
• Birla India Opportunity Fund
• Birla Sun Life New Millennium Fund
• ICICI Prudential Technology Fund

Not all of them are 'pure play' IT funds. While UTI Software, SBI IT, Franklin Infotech, Kotak Tech Funds have over 90% of their portfolio in software; other funds have significant proportion of holdings in telecom and media sectors. In particular, Birla India Opportunity Fund has only ~42% of its portfolio in software, the rest being in a variety of other sectors like electrical equipment and pharmaceuticals.

All these funds (except UTI IT Fund) have been in existence for over five years, having weathered crashes in 2002 and May 2006, and having ridden sustained bull runs in the interim. The UTI Software Fund has been in existence for only two years and investors should discount for this while comparing returns.

The graph below shows the five-year return and annualised volatility of IT sector funds, compared to the BSE IT sector index. The size of the bubble represents the fund's AUM (assets under management) in March 2007.

As seen in the graph, DSPML Technology Fund, ICICI Prudential Technology Fund, Birla Sun Life New Millennium Fund and SBI Infotech Fund have all outperformed the IT index (which itself has delivered an annualised return of over 25% in the last five years).

However, it is important to note that the last year in particular has been a year of exceptional returns for the industry as a whole; and one must keep this in mind while projecting future performance.

Franklin Infotech and Birla India Opportunities Fund are large cap oriented, while the others have a greater blend of market cap. Thus, these two funds have weathered the crash of May-June 2006 much better than the others (with a 12%-18% fall in NAV compared to over 20% for others).

Prudential ICICI Technology Fund, in particular, has been very aggressive and volatile; as has SBI Magnum IT Fund to a lesser degree. SBI IT Fund has seen several fund manager changes (including entry and exit of the high-profile Sandip Sabharwal), but we still it believe it is in very capable hands currently under Sanjay Sinha and Jayesh Shroff.

Birla Sun New Millennium Fund, on the other hand, has shown more stability in returns -- lower volatility and better performance in bear phases. Its fund manager Mahesh Patil is well reputed and has delivered good performance in other funds managed as well (such as Birla Sun Life Equity Fund).

On the whole, given the cautious outlook for this industry in the coming year, conservative investors may opt for Birla Sun Life New Millennium and Franklin Infotech Funds, while DSPML Technology or SBI Magnum IT Funds are options for the more aggressive. In either case, the movement of the Rupee-US$ exchange rate and the performance of OECD economies (US in particular) are crucial to watch out for.

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The author is Director, PARK Financial Advisors Pvt. Ltd., Mumbai. He is an IIM-Ahmedabad alumnus. He can be contacted at tilotia.akhilesh@parkfa.com