Tudor portfolio manager discusses her approach to finding alpha in the tech sector amidst rising rates.

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Despite the possibility of higher interest rates, the tech industry has faced challenges in 2022. However, one tech investor remains optimistic and is investing in the sector despite the market volatility.

Tudor Investment Corp.'s Ulrike Hoffmann-Burchardi recently unveiled a new strategy called T++, which concentrates on technology stocks. In a conversation with Delivering Alpha, she disclosed her current hedging approach and where she's discovering alpha in the technology industry.

The video shows a person performing a yoga pose.

How does it feel to be a tech investor during this market regime change?

Ulrike Hoffmann-Burchardi: The next generation of digital transformation is driven by data, which is predicted to grow more than 100 times over the next 10 years. This presents significant investment opportunities in data infrastructure, semiconductors, and digital and data-first businesses. There is much to look forward to. However, the second part of your question focuses on the current situation. While the prospects of new technologies are exciting, the main concern is the unprecedented levels of fiscal and monetary stimulus that have led to inflationary pressures in our economy. The Fed is now seeking to control these pressures by raising interest rates.

With the backdrop of fiscal and monetary stimulus, low equity valuations mean we are discounting future cash flows with higher discount rates. However, it's important to recognize that this tide has lifted all boats, not just technology. When the tide recedes, only those companies with stronger secular tailwinds, the best business models, and world-class leadership will still be standing. It's challenging to find another sector that has as much of these factors as technology. So, while the Fed can change the discount rate, it cannot change the digital inflection of our economy.

Do you view the sharp decline in valuations as a concern or a buying opportunity?

Looking at the sharp asset price corrections, one can invert the different asset classes' prices in terms of future rate hikes. For instance, high-growth software now prices in a one percent increase in the 10-year rate, while the Dow Jones is still at a zero percent rate hike. This suggests that there is some diversity of risk being priced in. It seems that the sharp corrections in high-growth software, at least in the short term, are more related to positioning and flows rather than actual fundamentals.

Paul Tudor Jones of your firm stated that the investments that have performed exceptionally well since March 2020 are likely to underperform during the current tightening cycle. As a result, you should focus on high-growth technology, which is where you spend most of your time and research. Do you concur with this viewpoint, and does it cause you any concern on the long-term?

Prepare for an environment with higher rates by adjusting your playbook, as stocks with further out cash flows are more vulnerable than those with near-term cash flows. Despite valuations coming down, companies that outperform their growth rates can offset multiple compression. Additionally, certain companies are indexed to data growth, which will not stop despite the Fed stopping its balance sheet growth.

There are two opportunities to deliver Alpha: stock selection and adjusting hedges when certain asset classes overreact in the short term. As we price in four rate hikes this year, the pace of increases in interest rates should start to slow down for the rest of the year.

Given the backdrop you described, does that imply that technology is currently at its fundamental basis? Does this increase your confidence to purchase in this market?

As long-term fundamental investors, our first priority is to maintain investments in companies that we believe will be the winners of the digital age. Our approach is to hedge, which can provide staying power in our investments for the long term. Despite the negative connotations associated with hedge funds, hedging can actually be beneficial in this environment. To offset the duration risk of our cash flows, we can invest in a basket of stocks with similar cash flow durations.

Given the recent correction in high-growth software, the risk-reward ratio of hedging high-growth names with other high-growth names may have decreased. Therefore, it is more important to tactically adjust your hedges if you believe that certain assets have overshot in this environment while others have not reacted appropriately.

What sectors are you interested in on the long side and which sectors are you interested in on the short side?

In the era of digital transformation, two sectors stand out as particularly interesting: data infrastructure and semiconductors. These industries are crucial for translating data into insights, similar to the picks and shovels strategy of the Gold Rush. Semiconductors, in particular, are the digital engine room of our economy, with an industry structure that has become increasingly benign over time. The number of publicly traded semiconductor companies has decreased over the past decade.

The barriers to entry in the semiconductor industry have increased across the entire value chain. However, the design of a chip has only tripled in complexity when going from 10 nanometers to 5 nanometers. Despite this, the competitive landscape remains benign due to the growing end demand. For example, the automotive industry is expected to see a more than five-fold increase in semi content over the next decade. Additionally, the data infrastructure market is still in its infancy, with only about 10% of software being data infrastructure software. As companies grapple with the need to manage large and varied data sets, they will be forced to overhaul their data infrastructure, making it incredibly difficult to replace once installed.

What is the best way to hedge market fluctuations on the short side?

Hoffmann-Burchardi believes that hedging against higher interest rates is the primary objective of matching cash flow duration patterns. However, he suggests that at this point, the market has overreacted to the growth software sell-off, and it's more about using hedges to price in an overall slowdown on the index level rather than in specific technology areas.

Perhaps hedging indexes is a way to safeguard against the potential downside of longer bets.

In the short term, some markets have experienced carnage while others have not reacted significantly to the higher interest rate environment.