Beware The Value Traps In Indexes

Disruptive-innovation investing can be a hedge against the pitfalls of passive investing.

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Reviewed by: Heather Bell
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Edited by: Heather Bell

Catherine Wood, founder and CEO of ARK Invest, is a big believer in the power of disruptive innovation. It’s what ARK’s entire investment philosophy is built around. The firm, with five ETFs under the ARK brand, has teams of analysts researching everything from 3D printing to autonomous vehicles that find coverage in its ETFs. ETF.com caught up with Wood at this week’s Inside ETFs conference for a brief interview.

ETF.com: What do you see as the opportunities in the current market environment?

Catherine Wood: We’re all about disruptive innovation, all about the future, and we have never seen so many technology platforms evolving to serve the future. They're going to be very disruptive. There’s the genomic revolution—DNA sequencing is critical to that theme.

There’s the next-generation internet—so artificial intelligence, machine learning, and the internet of things is critical to that. There’s robotics and automation, which includes autonomous taxis; we see that theme evolving much faster than people now think, with Tesla leading the charge, for example.

We see energy storage changing dramatically. We’re going to move from the internal combustion engine to electric vehicles; we think within the next five years there will be demand for 30 million electric vehicles around the world, versus less than 1 million sold last year—so, huge opportunities.

The last technology platform that we’re exposed to is blockchain technology. We’re exposed to it through an OTC instrument called GBTC, which is the Bitcoin Investment Trust. We were the first—and I think the only—public asset managers with exposure, certainly in the ETF space, to that.

Right now, the whole bitcoin platform is a $14 billion platform. We think it’s going to end up in the trillions. So we’re looking for big ideas, the next big thing. That's what we’re all about.

And what we’re also all about is creating portfolios that are complements to more traditional portfolios out there. They don’t have what we have in our portfolios. Our portfolios are extremely active. What they have in their portfolios are more value traps than they now realize, if we’re right on our research. If they complement their portfolios with ours, they will have an automatic hedge against disruption.

ETF.com: What does disruption mean for a portfolio? For example, if autonomous vehicles take off, will that damage traditional car dealers?

Wood: Yes, it will damage all of the traditional auto ecosystem, whether it’s the manufacturers, the dealers or the after-market auto parts. It will change the insurance industry radically, because 90% of all fatalities are caused by human error in cars. If you take away 90% of the fatalities, the structure of the auto insurance industry and life insurance industry has to change drastically.

It’s going to change infrastructure. We’re not going to need 80% of the parking places if we’re right on autonomous taxis. We have five parking spaces for every vehicle now. We’ll only need one in the future for each autonomous taxi.

So that will change the real estate industry toward maybe more office buildings and more retail, although bricks and mortar seems to be going away too. Even in our own homes, that third or second garage space will be turned into an office or a playroom. It will enhance real estate that way as well.

 

ETF.com: Is disruptive innovation a destructive force for your portfolio if you're not prepared for it?

Wood: It’s going to cause a lot of value traps in traditional portfolios if you're not prepared for it. We think there are many more value traps evolving now than there have been in the last 30 years. Because, as I mentioned before, we don’t have just one general purpose technology platform evolving like we did with the computing age with the internet. We have five at the same time. So they're going to hit every sector and create value traps in every sector.

In the ’80s, I was a newspaper analyst, so I saw how they made their profits. It was help wanted, retail and real estate. All of those have disappeared. I saw Monster.com, and I said, “I'm out of here.”

But what happened after that? They became value stocks, because they were huge cash cows with very low multiples. They were value stocks, which had decent performance until they were destroyed. We’ve just decided not to participate in that value stage, and move as far away from the destruction as we possibly can, into the creation. That’s what we’re all about. We’re in the creativity part, not the destruction.

ETF.com: What do you see as the risks to disruptive innovation?

Wood: Increased regulation, increased taxes or increased government interference is usually a bad thing, but we’re going in the other direction here in the United States. So that's good.

I'm going to answer the question a little differently, more from the investing side. When we go through periods of turmoil in the stock market, because of the shift in the market toward ETF strategies, which tend to be passive, you have a rush back into passive strategies or index-based strategies.

That damages our stocks in the short term. 2008-2009 was a perfect example of this: While everybody rushed back to their index stocks and the biggest index players, the companies that came out of that crisis winning market share were the companies our firm was invested in. Their stocks went down. We scooped them up, and they came flying back.

I think there are short-term misperceptions about where the risk in the market is. We think more risk is in the indexes because of disruptive innovation and because of the value traps that it’s going to create than there is in our portfolios.

ETF.com: I guess agility and nimbleness are crucial to disruptive-innovation-type investment?

Wood: In terms of our turnover in the portfolio, name turnover is in the teens. But because of volatility in the market, we get all kinds of opportunity to trade around the volatility. Our turnover can reach 75% because we were buying the heck out of salesforce.com in 2008, 2009, saying, “Salesforce is an answer to the question of how to cut costs 30%. So let’s buy this,” and it came out flying. Yes, agility is important, but conviction based on research is more important.

 

Heather Bell is a former managing editor of etf.com. She has also held editorial positions at Dow Jones Indexes and Lehman Brothers. Bell is a graduate of Dartmouth college and resides in the Denver area with her two dogs.