An Outperforming, Relatively Unknown Smart-Beta ETF Factor

Investors looking for a long-term investment option may do well with a smart-beta exchange traded fund strategy that focuses on innovative companies that actively look for the next big thing.

On the recent webcast, Knowledge, the “Super Factor” for Buy-and-Hold Investors, Steven Vannelli Managing Director and Chief Investment Officer of Gavekal Capital, helps explain the potential benefits and shortcomings of smart-beta ETF strategies.

For instance, many have turned to traditional factor-based investments that focus on value, small capitalization stocks, momentum, low volatility and quality. However, Vannelli argues that these factors go in and out of style during market cycles.

“In the 2003-2007 cyclical bull market, size and momentum were the best performing factors. Quality and low volatility were the worst performing factors,” Vannelli said. “In the 2009-2016 cyclical bull market, quality was the best performing factor. Value has been the worst performing factor.”

Alternatively, Vannelli believes investors could generate alpha through the little known Knowledge Effect anomaly. Specifically, investors should focus on companies that invest large sums of money in producing knowledge.

“For more than 20 years academic researchers have studied the impact of current accounting standards which force companies to expense R&D investments (rather than treat them as capital investments), thereby rendering investment in innovation invisible to investors,” Vannelli said. “This archaic accounting treatment, enacted at the dawn of the semiconductor era in 1974 when knowledge accelerated exponentially, created a new market anomaly, the Knowledge Effect.”

Essentially, most analysts have not accurately accounted for R&D investments as a separate factor, potentially undervaluing the effect of knowledge investments on a company’s growth.