Innovation: The Risks of Under-Allocation
This article is an excerpt from our recently published white paper: Rethinking Asset Allocation: Why Innovation Deserves A Strategic Allocation In Investor Portfolios. In this article, we evaluate the risks of portfolio under-allocation to innovation.
ARK believes that asset allocators do not have enough exposure to innovation in the public equity markets. We estimate that disruptive innovation will add $50 trillion to global equity market capitalizations by 2032. Today, these technologies account for less than $6 trillion, suggesting that they will deliver a 21% compound annual rate of return during the next 12 years. As technologies emerge and transform entire industries, investors in traditional benchmarks may face more risk than historically has been the case. In the 52 years from 1964 to 2016, the average lifespan of a stock in the S&P 500 dropped roughly 25%, from 33 years to 24, according to Innosight. By 2027, as shown in Figure 1, it is likely to drop another 50% to 12 years as transformational technologies disrupt broad-based equity indices, impairing the “old guard”. In other words, we believe in little more than a decade the S&P 500 is unlikely to be even a shadow of itself today.
In our view, the turnover of stocks in the S&P 500 is accelerating because innovation is disrupting or disintermediating the traditional world order at an accelerated rate, creating value traps – stocks that are “cheap” for a reason. Stocks in industries particularly at risk – big pharma, banks and other financial services, fossil fuel-based energy, auto and auto-related manufacturers, telecommunications, transportation, retail – dominate broad-based indices today. In fact, their market capitalization weighted index structure may be exacerbating the risk, reflecting success stories from the past, not the future. We 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.
At the portfolio level, disruptive innovation should be particularly frustrating, if not unnerving, for investors committed to style boxes. Rapid change can create winners and losers, perhaps slower than expected at first, and then blazingly fast. As new technologies enter parabolic trajectories, large cap companies can lose market share at alarming rates, suggesting that traditional style-box and benchmark-sensitive strategies should find hedges against such disruption. For example, fintech companies seem to have evolved much faster than expected and already are competing successfully against large financial institutions. Relative to bricks and mortar banks saddled with infrastructure, “digital wallet” providers can acquire customers at a fraction of the cost thanks to the convergence between and among three technologies: cloud computing, mobile devices, and artificial intelligence. As a result, they have more digital users in the US today than the largest banks. Yet rarely, if at all, are digital wallet providers weighted more heavily than banks in value or growth portfolios today. ARK believes that well-structured core portfolios should include not only hedges against disruptive innovation but also exposure to the record-breaking number of exponential growth opportunities that we believe it is creating. Therefore innovation should deserve a more strategic allocation in global equity portfolios. Given market capitalization biases, multi-quarter profitability requirements, and one-year stock listing minimums, traditional index methodologies can sometimes disqualify the stocks of innovative companies that are sacrificing short-term earnings and investing aggressively to capitalize on exponential growth opportunities. We believe this results in an under-allocation to innovation. In our view, 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. Traditional market capitalization and style-focused equity strategies are centered around benchmarks and indices which are backward-looking and do not adjust rapidly to change. As a result, equity strategies built on past success may miss the growth that innovation is brewing for the future.