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.
[related_stories]Vannelli also pointed out that the knowledge factor has been the best performing factor over the past 15 years, outperforming all other factors by a wide margin and holding up in all market environments, which may benefit more buy-and-hold investment styles. For instance, in the bear market of August 2000 to March 2003, the knowledge factor only trailed the low-volatility factor. On the other hand, in the 2003 through 2007 cyclical bull, the knowledge factor was the fourth best performing factor. During the financial downturn, the knowledge factor was the third best performer. In the ongoing bull cycle, the knowledge factor was the best performing factor.
“The Knowledge factor has outperformed in 87.5% of the years since 2000, making it an ideal ‘buy and hold’ strategy,” Vannelli said. “It has outperformed other factors by at least 66%.”
ETF investors can tap into Gavekal’s Knowledge Effect investment strategy through its of “Knowledge Leaders” ETFs, including the Gavekal Knowledge Leaders Developed World ETF (NYSEArca: KLDW) and the Gavekal Knowledge Leaders Emerging Markets ETF (NYSEArca: KLEM).
The Knowledge Leaders ETFs select companies based on the innovation process and other criteria, including characteristics like intangible property as a percentage of assets, intangible investments as percentage of sales, gross margins, financial leverage, net debt as percentage of capital, operating cash flow margin, free cash flow margin and return on invested capital.
Through its screens, the Knowledge Leaders ETFs hold the largest concentration of passing companies in health care, technology and consumer sectors. On the other hand, the pass rate is lowest for companies in the financial, energy and utilities sectors. Moreover, the Knowledge Leaders portfolio shows a relatively high correlation to the small-size and quality factors, which help explain the outperformance in bull markets and lower drawdowns in bear markets, and the strategy exhibits relatively low correlation to momentum and low-volatility factors.
Financial advisors who are interested in learning more about the Gavekal smart-beta strategies can listen to the webcast here on demand.