ETF Trends spoke with ARK Invest Portfolio Manager Renato Leggi, whose recent paper, Rethinking Asset Allocation, explored the role of innovation and why it deserves to be a strategic allocation in investor portfolios.
In looking at why long-term investors are currently finding it difficult to balance between growth and volatility, Leggi notes how investors appear more risk-averse since the global financial crisis of 2008. Long-term investors seeking growth-oriented strategies in the public equity markets also want downside protection during periods of heightened volatility, making it difficult to balance between growth and volatility.
“While many investors perceive innovative technologies and their associated stocks as volatile and risky, themes and their underlying stocks tend to be idiosyncratic, such that collectively we think they can provide enough diversification to minimize risks and lower volatility,” Leggi explains. “As technologies emerge and transform entire industries, investors in traditional benchmarks may face more risk than historically has been the case. In our view, innovation is disrupting or disintermediating the traditional world order at an accelerated rate, creating value traps – stocks that are ‘cheap’ for a reason.”
He continues, “We believe disruptive innovation is key to the long-term growth of company revenues and profits. An allocation to innovation has the potential to increase risk-adjusted returns in global equity portfolios in the long term.”
Given the uncertainty currently taking place, there are creative strategies that investors have adopted. Investors appear to be adopting strategies that are less correlated with broader equity markets. Ark believes investors are likely to evolve asset allocation and portfolio construction strategies, increasingly incorporating disruptive innovation and identifying stocks poised to benefit from trends misperceived, misunderstood, and mispriced in the market.
During times of fear, uncertainty, and doubt, businesses and consumers are more willing to change their behavior and seek innovative products and services that are more productive, cheaper, faster, and/or more creative. As a result, innovation takes root and typically gains significant market share during tumultuous times. Nonetheless, their shares are hit disproportionately in the early stages of correction because they tend not to be significant positions in the broad-based indexes to which many investors flock during times of turmoil.
That said, they typically recover much faster than many of the value traps that populate the traditional indexes. Therefore, in periods of market distress and volatility, investors are seeking innovation-focused strategies to gain exposure to the record-breaking number of exponential growth opportunities.
Comparing Emerging Market Strategies
The white paper draws a comparison between innovation and the adoption of Emerging Market strategies in the late 80s. As Leggi explains, “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. Many investors resisted exposure to developing markets based on the volatility associated with geopolitical uncertainties, corporate governance, and liquidity.”
“With time, however, they observed low correlations between and among the stock returns of the various developing nations, as well as growth rates that far surpassed those in the developed world. Investors concluded that broad-based exposure to developing markets offered enough diversification to minimize idiosyncratic risks and lower volatility, resulting in higher risk-adjusted return. We are seeing the same story play out with innovation investing. Investors are starting to notice the diversification benefits that innovation-focused strategies offer to a global equity portfolio, much like they did when they first started introducing emerging markets exposure to their portfolios in the late eighties and early nineties.”
As far as identifying an innovation strategy, the question is whether investors have to invest against market trends or seek disruptive change. From Ark’s perspective, investors should evolve their traditional “style box” investment strategies to capture innovation and capitalize on the multi-trillion-dollar opportunity it creates.
Because technology is permeating every sector of the global economy, innovation cannot be boxed into sectors, geographies, or market caps. To identify innovation, Ark combines a top-down and bottom-up research approach. From the top-down, they seek out the technologies that experience massive cost declines, cut across the sector, and span further innovation. From the bottom up, Ark then identifies the companies best positioned to be a leader, enabler, or beneficiary of that innovation.
“It’s important to have a long-term time horizon and not get distracted by short-term market movements and noise,” Leggi notes. “Through this investment process, we aim to provide forward-looking exposure and a strategic allocation to innovation to our investors.”
As far as what investors can aim for by making a strategic allocation to innovation, Ark believes that asset allocators are currently under-allocated to innovation in the public equity markets. They 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.
“Therefore, we believe making a strategic allocation to innovation should not only provide a hedge against disruptive innovation but also exposure to the record-breaking number of exponential growth opportunities that we believe it is creating. We estimate that disruptive innovation will add $50 trillion to global equity market capitalizations by 2032,” says Leggi.
Today, these technologies account for less than $6 trillion. An allocation to disruptive innovation can provide access to long-term growth, portfolio diversification opportunities, and moderate-to-high risk/reward potential.
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