Innovation ETFs: Real Deal Or Gimmick?

[This article previously appeared in our September issue of ETF Report.]

Technological innovations are so integrated into our lives that we don’t think about their impact. Beyond the latest electronic gadget, technology has enhanced everything from medicine to food.

Within the past 12 months, several new exchange-traded funds debuted promoting the idea that innovation is an investable theme. These funds are more than simple technology sector ETFs; rather, their idea of innovation is to look at companies using technology to push their industry forward. In fact, many of these companies aren’t necessarily considered technology firms; instead, they inhabit other sectors like energy or health care.

The biggest of these funds in terms of assets under management by far is the iShares Exponential Technologies ETF (XT), based on the Morningstar Exponential Technologies Index. It’s backed by fund manager Ric Edelman, founder and chief executive officer of Edelman Financial, who seeded the fund with about $560 million after its launch.

There are two other fund families focusing on technological innovation. ARK Investment Management’s funds include four actively managed ETFs: the ARK Genomic Revolution Multi-Sector ETF (ARKG | D-36), ARK Industrial Innovation ETF (ARKQ | D-44), ARK Web x.0 ETF (ARKW|D-29) and ARK Innovation ETF (ARKK | D-32). ARKK contains all three of the other ARK innovation funds. Meanwhile, the newly launched Gavekal Knowledge Leaders Developed World ETF (KLDW) and the Gavekal Knowledge Leaders Emerging Markets ETF (KLEM) follow Gavekal’s Knowledge Leaders indexes.

There is some debate about whether technological innovation is an investment theme, and it may just be pure coincidence that within the space of a year several funds launched based roughly on the same idea without being clones of each other. Technology certainly has blurred the lines regarding the categorization of certain firms based on their business lines—think of Tesla being a car company and focused on energy storage. Yet at least one industry watcher said the name “innovation” is just growth with better marketing.

Another Paradigm Shift?
Managers of these funds said when thinking broadly about innovation, consider how the advent of different technologies changed life over the centuries, such as the printing press, the steam engine and electricity.

Edelman said previously he went to iShares to create a fund focusing on “new economy” companies, a fund that would include everything from robotics to artificial intelligence to energy and environmental systems to medicine. Innovation is neither a market sector nor a geographical issue, but a fundamental theme. Given recent technological breakthroughs, he has said, this fund could not have existed even a few years ago.

XT launched March 23 and has about $689 million in assets under management. Information technology and health care make up the bulk of the fund, a little more than 60% combined, with 67% of the companies domiciled in the U.S. It has an expense ratio of 0.47%.

Targeting ‘Disruptive’ Technology
XT has the most assets under management of the innovation funds, but it wasn’t the first on the scene. ARK Investments’ fund ARKQ launched on Sept. 30, 2014, ARKW launched on Oct. 7, 2014 and ARKG and ARKK launched Oct. 31. These funds focus on the theme of “disruptive” technology.

Tom Staudt, associate portfolio manager at ARK, says the funds look at what they call “general purpose technology platforms” that will drive the economy across sectors. Those platforms include cloud computing and big data, automation and robotics, and genomic sequencing.

All four funds have expense ratios of 0.95% and have a heavy domestic tilt, with at least 71% of holdings in U.S. companies. By sector breakdown, ARKW has 77% in technology; ARKQ is 56% technology-focused; ARKG is 80% focused on health care. ARKK holds all three funds and comprises 48% ARKW, 31% ARKQ and 20% ARKG.

As of July 20, assets under management were $14 million for ARKQ, $13.1 million for ARKW, $9.7 million for ARKG and $7.7 million for ARKK.

At first blush, the funds appear to be heavily weighted in technology or health care, but Staudt says they’re really cross-sector funds that fit into a portfolio’s growth allocation. The funds’ construction takes advantage of the blurry lines of classification across sectors. For instance, investors who own the Technology Select Sector SPDR Fund (XLK | A-90), don’t own Amazon, the largest cloud provider in the world.

“The reason they don’t is because [Amazon] is considered a consumer-discretionary company. They don’t have Netflix, the largest streaming-video provider in the world. Why? It’s consumer discretionary,” he said.

Staudt doesn’t necessarily consider innovation to be a new investment idea, but he suggests the current interest in innovation comes from buyers getting comfortable again with technology investing as a whole after dealing with “scar tissue from the tech and telecom bust” that started in 2000.

A Semiconductor Spark
Steven Vannelli, chief investment officer for Gavekal Funds, says they trace back the idea of technological innovation influencing everyday life to the introduction of the semiconductor and how computing power grew.

The exponential growth in computing technology is commonly known as Moore’s law, named after Gordon Moore, co-founder of Intel.

The semiconductor’s influence is seen in what Gavekal calls “the knowledge effect,” and Gavekal built indexes around companies using this to change how their industries develop. The KLDW and KLEM ETFs are based on those benchmarks. Launched July 8, the funds each have $2.5 million in assets under management as of July 20.

Companies using the knowledge effect outperform less innovative companies, Vannelli says, and part of that is due to how the U.S. Financial Accounting Standards Board forces firms to expense their knowledge investments in the period in which they were incurred. This doesn’t allow companies to treat knowledge investments as assets—unlike the way physical objects are accounted—so it skews what information investors have, he says.

Gavekal picks the firms for their funds by reorganizing what’s publically recorded on a company’s balance sheet and treats investments in intellectual property the same way a company might treat equipment.

Growth Rebranded? …
Christian Magoon, chief executive officer of YieldShares, and an industry veteran who launched many ETFs, is skeptical about whether innovation is a true investment theme.

“If you launched a ‘growth-leaders fund,’ there would be yawning in the marketplace. But if you launched an ‘innovation fund,’ people would say ‘oh, innovation, that’s interesting.’ It has a little bit of a branding/marketing feel to it,” he said.

Paul Britt, senior analyst at FactSet, says investors interested in an innovation fund need to look closely at the holdings, because some of them contain big-cap names rather than small- or midcap firms most people associate with innovation, noting the PureFunds ISE Mobile Payments ETF (IPAY) as an example.

“That’s hot and trending, and I’m picturing a bunch of college kids in a loft somewhere cooking these things up. But if you look under the hood, the top holdings [in IPAY] are Visa, MasterCard and Amex. You’re thinking ‘how innovative is that?’” he said.

Britt agrees that blunt sector classification is becoming fuzzy, such as in the Amazon and Netflix examples. He said investors wanting a nuanced approach should review a firm’s revenue attribution to understand what portion is actually focused on the potential innovation theme.

“That speaks to the classification notion of what these companies are, and what bucket you put them in,” he said.

What makes these ETFs stand out a bit is that they may hold some names not normally represented in traditional indexes, Magoon says, since many leading innovation firms usually have smaller market caps or are emerging companies. He says these are likely more volatile stocks, so owning a basket of 20 or 30 companies in a diversified ETF is less risky than owning, say, a biotech sector ETF.

One thing to consider about these funds is their expectations that they will target future growth, Britt says.

“It’s one thing to name these companies; it’s another thing to say that these things are going to outperform the market—that the market has underpriced them. At end of the day, they might not outperform Nabisco or something else,” he said.

The overall market is currently rewarding growth, which benefits these ETFs, Magoon says, but if value investing becomes popular, it’s hard to say how it will affect the funds.

Britt says investors could get some perspective on innovation funds by looking back at what was hot a few years ago, such as renewable energy. He used the PowerShares Global Clean Energy Portfolio (PBD | D-23) as an example of a fund that is down significantly from its highs.

“That’s innovation, but it’s not so fresh. It may give you a little perspective on what will it feel like in five years when we’ve moved on to the next thing. Some of these funds will be with us, some not,” he said.

… Or A Lasting Theme?
Certainly, XT, the largest of these funds, has a heavy growth tilt, though it’s not at all a pure growth vehicle. If you look at the Morningstar classifications of the holdings, 46% of the portfolio is in growth stocks, with 32% in blend and 21% in value. In other words, more than half of the fund is in nongrowth stocks. By contrast, 33% of the SPDR S&P 500 ETF (SPY | A-98) is classified as growth.

However, advisors using the funds would beg to differ with the growth characterization. John Eberle, chief investment officer of Fiduciary Financial Partners, notes that he’s been using the firm’s actively managed mutual fund since not too long after it launched, and that he would be moving some of those assets into the ETFs. The ETFs, he points out, don’t need to maintain cash reserves, unlike the mutual fund, which at times has roughly 20% of its assets in cash. Eberle also doesn’t see Gavekal’s approach as a growth-oriented strategy.

“I could see these being perceived as more growth-oriented, but I would think of it in a different way. They’re trying to define an asset that’s not defined in the balance sheet, like intangibles,” Eberle said, adding that he considers himself to be a value investor, as he believes growth expectations are frequently overestimated.

“Whether the intellectual capital is generated internally or through M&A, it shouldn’t make a difference. Value or growth, what they’re getting is an asset that is—or more to the point, is not—on the balance sheet that will generate revenue and profit opportunity that other people are not accounting for,” he said.

For Ric Edelman, who was the main driving force behind XT, the growth characterization seems to be purely coincidental. He notes that growth qualities were not a part of the selection methodology.

“The fund was designed to contain companies that are leaders in using or developing exponential technologies, and growth was not a criteria,” he said.

And while Edelman doesn’t think the launch of seven similarly themed funds within the space of a year was necessarily a coincidence, he’s not convinced it’s a widespread trend, adding that he’s not aware of any other similar funds in development. He is, however, a firm believer in the exponential technologies theme that underlies XT.

“I’m convinced that this particular theme is very important for investment portfolios, and will increasingly be viewed as an essential part of any asset allocation model,” he said.