By Matt Moberg, Senior Vice President, Portfolio Manager, Franklin Equity Group

Innovation has persisted through history, not always predictably or linearly, and often quite episodically. From AD 1 to 1820, economic growth in the Western world was approximately 6% per century¹, and real output took 12 centuries to double. It sped up dramatically during the 20th Century, when Americans enjoyed a real output doubling every 32 years².

Economists define these higher-growth periods as industrial revolutions. We are living through the Fourth Industrial Revolution. Its many technologies are blurring the lines between physical, digital and biological spheres. These technological and industrial advancements increase economic productivity, which is foundational to wealth creation. The average American only needs to work 11 hours per week to match the productivity of a 40-hour work week in the 1950s³.

Innovative companies can be found in many ETFs, but the nature of market-cap weighting means passive investors are often buying what has done well, not necessarily what will do well.

Asset managers have begun to offer ETFs that seek to capture the high performing innovators of the future through active management, identifying stocks with the best chances of succeeding in crowded marketplaces. ETF wrappers let us package some of our best ideas at attractive prices.

Innovation can be seen in any part of the global economy. We seek to invest in it wherever it occurs, regardless of sector classification, market capitalization or geographical location. Where we work, in Silicon Valley, there is a mindset that accepts change and disruption. This has spurred the growth of so many wonderful businesses at the forefront of changing our economy.

Yet innovation is widely misunderstood by investors. For every winning innovator, there are many more losers. It is possible to identify and capitalize upon significant inflection points, but in my view, investing in this area calls for experienced active managers.

Outperforming the equity markets is hard. Our team is constantly talking with thought leaders across industries; researching the latest developments; and meeting with companies, public and private, to understand the technologies and ideas that could have transformative potential.

Our investment process is designed to remove fear, panic and individual stock bias, which helps in making good decisions in times of crisis. This is the output of managing money through multiple past unprecedented events. Each crisis is an opportunity to refine, improve and learn.

Over the next decade, major technology-driven efficiencies or product improvements will impact many areas. We expect these to include insurance, medical diagnosis, automotive distribution, industrial design, the pricing and exchange of capital, and the analysis of data.

I believe this is an excellent time to invest in innovation. The COVID-19 pandemic will either accelerate it, as we see in many cases, or it will be immaterial to the long-term changes that are already transpiring. It need not change the accelerating pace of innovation that continues to drive our economy.

Money is flowing readily into vaccines and testing, which require genetic analysis. In e-commerce, video and voice communications development and usage are accelerating beyond initial expectations. Many of these companies may be worth considerably more than before the crisis if they can benefit from permanent or semi-permanent changes in consumer behavior.

There are many other good opportunities in the marketplace. History shows that investors are prone to making significant misclassifications, most frequently in areas that are new, and this can meaningfully impact valuations. A good example is animal health care: is it health care, or consumer discretionary? The growth of health care for companion animals has been a secular tailwind for many years, and we believe it will continue, but in which sector does it fit?

Rating agencies sometimes start out with misclassifications that may not reflect businesses holistically. Search and social networking are other examples: are they technology companies, as long widely perceived, or media? Some see them as media companies because greater than 90% of their revenue comes from advertising dollars. Others continue to view them as technology.

We try to take advantage of these misclassifications and the spreads they can create in pricing.

Equity markets must wrestle with the duration and severity of the coronavirus and the longer-term impact it will have on the global economy, the supply and demand outlook for oil, and governments’ reaction to these events. Passive ETFs can track these macro events, but my view is they cannot tell investors whether the individual companies in their “innovative” funds really are.

Change is happening rapidly, and I believe only through active management is it possible to identify and capitalize upon the inflection points that make ETF investing in innovation compelling.

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Endnotes:

  1. Source: Maddison, A. “Poor until 1820,” The Wall Street Journal, January 11, 1999.
  2. Source: Gordon, R. 2016. The rise and fall of American growth: The U.S. standard of living since the Civil War, Princeton: Princeton University Press.
  3. Source: Brynjolfsson, E. and A. McAfee. 2014. The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies, New York: W. W. Norton & Company.