The Gavekal Knowledge Leaders Developed World ETF (NYSEArca: KLDW), the first exchange traded fund based on the so-called Knowledge Effect, has been an outperforming international play.
Since its inception as of July 31, 2016, KLDW has outpaced the MSCI World Index by over 5.5 percentage points. Over the past year, KLDW increased 7.4% while the iShares MSCI World Index Fund (NYSEArca: URTH) rose 2.5%. Year-to-date, KLDW increased 10.1%, compared to the 6.3% advance for URTH.
“The last 12 months proved innovation truly can be indexed and captured in an ETF,” Steven Vannelli, CFA, CEO and Chief Investment Officer of Gavekal Capital, said in a note. “In a year in which global markets were negative, stocks of Knowledge Leader companies performed as the academic research predicted: they outperformed relative to the overall market.”
KLDW tries to generate alpha through the little known Knowledge Effect anomaly. Specifically, investors should focus on companies that invest large sums of money in producing knowledge.
Gavekal has argued that analysts have not accurately accounted for R&D investments as a separate factor, which has led to many undervaluing the effect of knowledge investments on a company’s growth.
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The Knowledge Leaders ETF 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.
“The Knowledge Effect is grounded in academic literature,” according to Gavekal. “It was first discovered in a series of studies in the 1990s where NYU’s Baruch Lev analyzed 20 years of financial data and discovered an association between a firm’s level of knowledge capital and its subsequent stock performance. Further research advanced the findings, and in 2005, Lev proved the existence of a market inefficiency attributable to missing information about knowledge investments. This phenomenon leads highly innovative companies to deliver persistent abnormal returns.”
Through its screens, the Knowledge Leaders ETFs hold the largest concentration of passing companies in technology and consumer cyclicals. 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.
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According to a press release, KLDW’s 1-year risk-adjusted performance reveals Knowledge Leaders’ tendency to deliver excess returns while also falling less during periods of market weakness. The ETF showed greater total return and alpha than all six of the top benchmark indices, including the FTSE Global All Cap Index, FTSE Developed Index, MSCI All Country World Index, MSCI World Index, FTSE Developed ex US All Cap Index and MSCI EAFE Index, over the year ended July 31. Furthermore, KLDW had a lower max drawdown than all six of the top benchmark indices over the same period.
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