Innovation as an Asset Class?

Growth, Value, Blend…Large, Small and Mid. We are all familiar with the traditional style buckets for equity allocation. At the same time there is the option to invest in fixed income, commodities and alts to have diversification across asset classes. But what about innovation?

Innovation is defined as 1) a new idea, method, or device : NOVELTY; 2) the introduction of something new. In the spirit of innovation, the team at ARKInvest suggests something new when it comes to asset allocation. In a paper that was recently published, they suggest adding “Innovation” to the traditional style buckets for equity allocation like so:

The rationale is interesting in my view. The team notes that from 1964 – 2016, the average lifespan of a stock in the S&P 500 has fallen by 25% (33 years to 24 years). They estimate that by 2027, this number will fall by another 50% to 12 years. What is causing this decline? In a word innovation. From the paper, which can be found here:

In our view, the turnover of stocks in the S&P 500 is accelerating because innovation is disrupting or disintermediating the traditional world order at an accelerated rate, creating value traps – stocks that are “cheap” for a reason. Stocks in industries particularly at risk – big pharma, banks and other financial services, fossil fuel-based energy, auto and auto-related manufacturers, telecommunications, transportation, retail – dominate broad-based indices today. In fact, their market capitalization weighted index structure may be exacerbating the risk, reflecting success stories from the past, not the future. We believe technological disruption will cause both value destruction and value creation during the next decade, making it imperative that investors seek to position portfolios on the right side of change.

They go on to use fintech as an example:

…fintech companies seem to have evolved much faster than expected and already are competing successfully against large financial institutions. Relative to bricks and mortar banks saddled with infrastructure, “digital wallet” providers can acquire customers at a fraction of the cost thanks to the convergence between and among three technologies: cloud computing, mobile devices, and artificial intelligence. As a result, they have more digital users in the US today than the largest banks. Yet rarely, if at all, are digital wallet providers weighted more heavily than banks in value or growth portfolios today.

The paper makes a lot of interesting points such as how in times of uncertainty and doubt businesses and consumers may be more willing to embrace changes to their behavior. They also make an interesting point in comparing innovation as an asset class, or at least a style within the equity bucket, to Emerging Markets being added to the equity bucket in the late 1980s:

We believe a strategic allocation to innovation probably will evolve into a sub-asset class, as did the “niche” strategy of the 1980s—emerging markets. In the late 1980s and early 1990s, investors had little, if any, exposure to what has evolved into 13% of the global equity market capitalization3 and 60% of global gross domestic product (GDP) on a purchasing power parity basis. 

Interestingly, I am a big believer in innovation despite the fact that I have that tendency to lean bearish as I discussed in this post. Maybe it is my way of proactively looking for the positive side of the argument in order to balance out my bias. Regardless, innovation is what will lead to a vaccine for COVID-19. Innovation is what has allowed local restaurants to continue to serve local customers via the likes of Uber Eats or simply by setting up a web page on which orders can be placed for curbside pick. It was certainly innovation that allowed SpaceX to be the first private company to put humans in space this past weekend.

Because of my belief in innovation, I have actually been using it as part of the alternatives bucket for my own personal portfolio. This bucket contains assets such as gold, other commodities, real estate and then what I consider to be the key innovation trends in the market currently: Blockchain, Bitcoin, Cyber Security, Cannabis, E-Sports and the like (let me know if I have missed anything that you find interesting). Here is the “alt” bucket that I use when making allocation decisions in my personal account: 

And look who is at the top of the list based on a blend of 3, 6 and 12- month returns. ARK. In particular, the ARK Innovation ETF (ARKK). After that we have gold and another innovation, Bitcoin, via the Grayscale Bitcoin Trust. E-sports (NERD) rounds out the top four. For the record, I own ARKK, GDX and GBTC. 

But maybe I have it wrong. Maybe these innovative technologies don’t even belong in the same bucket as heavy rocks and real estate. Maybe they should have their bucket that warrants a separate allocation. Be that as it may, that’s where they sit for now and when they climb to the top of the list, I own them.

But as always, I don’t own them simply because they have been working. I want to have confidence that they are likely to continue to work. As it turns out, the ARK team has an entire family of ETFs tied to different innovation platforms that they have identified: Fintech, Genomics, Robotics / Autonomous Technology and others. All seven of the funds are also rated Very Bullish or Bullish in our model. 

Drilling down on the Fintech example used above, The ARK Fintech Innovation ETF has a Very Bullish rating compared to the SPDR S&P Bank ETF which has a Bearish rating. Additionally, while the two tracked each other closely until the beginning of 2020, during the market selloff and subsequent rebound, we can see that innovative fintech has been solidly leading the legacy banks.

 One of the hallmarks of the United States over the years has been innovation. We see an existing product and make it better. We see a problem and come up with a creative solution. The day we stop innovating is likely the day that we begin to lose our status in the global market. To bet against innovation is a synthetic short on the United States, any takers? I didn’t think so. Perhaps it does deserve it’s own allocation bucket in the equity landscape, or perhaps its own asset class?

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