Implementation Considerations When Targeting Post-COVID-19 Innovation

The inflection point from COVID-19 in our global society is likely to lead to an increasing need for innovative technologies that allow for more contactless interactions, advanced medicine, digital connectivity, and intelligent infrastructure. While some of these trends were in place before the pandemic, their trajectory will likely be amplified – with the potential for new themes and industries to emerge as behaviors evolve in a post-pandemic world. We discussed the implications for portfolios in our most recent midyear outlook.

The increasing number of options investors have to participate in these next-generation trends (NextGen trends) is one of the reasons that we developed a framework for classification as the first step in due diligence. Once you define a NextGen trends universe, it’s important to understand the construction approaches within a certain exposure.

In this blog, I will use the SPDR S&P Kensho New Economies Composite (KOMP) – a strategy that seeks to offer exposure to firms identified as innovative or disruptive and driving growth within a new economy – as an example of a broad-based innovative strategy and of how construction choices can make an impact; I will also explore the role KOMP can play in today’s portfolios.

Aren’t the FAANGs enough?

Given the prominence of certain mega-cap technology-oriented firms (i.e., FAANG stocks: Facebook, Apple, Amazon, Netflix and Google) in terms of market share and recent performance, a lot of investor conversations related to harnessing disruption are centered on why a portfolio does not need anything else — and this narrative is quite pervasive. However, it is a misguided view on how to participate in the sea change we are witnessing, as disruption happens throughout and further down the cap spectrum.

To illustrate this point, the chart below depicts the number and percentage of stocks up over 50% and 100% in KOMP as well as the S&P 500® Index. The performance is for both year to date and since the market bottom (03/23/2020) – when the realization of a new world order was starting to become clearer. As shown, 4% of the stocks in KOMP are up over 100% year to date, versus zero in the S&P 500 — a startling feat for the innovation-focused strategy, given the March market drawdown. And since the market bottom, those numbers are even greater.

As shown above, there are more stocks with sizable returns in a strategy focused on broad-based innovation than there are in just the broad market, which includes the FAANGs. In fact, the best-performing FAANG stock since the market bottom was Apple (up 58%), and nearly 30% of KOMP’s securities outperformed that. The chart below shows the same metric versus the rest of the FAANG cohorts.

Additionally, as shown below, only 24% of KOMP’s weight is comprised of stocks that are also in the S&P 500 Index. And since the market bottom, as well as year to date, the average performance of those stocks is less than the average performance of stocks in KOMP not in the S&P 500 Index, as shown below.

Based on this data, no, the FAANGs are not enough to capture the trends emerging in a post-COVID-19 world. Disruption happens further down the cap spectrum and goes beyond the glamour stocks that are well reported on in financial media.

Weighting is the hardest part

Selecting innovative firms is important. But, how they are then weighted is equally as important if the goal is to seek to capture holistic disruption differentiated from traditional market exposures. A simple exercise of reweighting KOMP from its modified equal-weighted approach to purely market cap reveals how concentration and stock-specific risk emerges.

A market cap version leads to the top 10 securities comprising half the portfolio, versus just 9% in the real KOMP. And the contribution to portfolio risk, based on the Bloomberg US Equity Fundamental Risk model, similarly illustrates the single stock risk. The top 10 securities in the market cap version contribute 41% of risk, versus 6.6% for the real KOMP.

Not surprisingly, the market cap diversification also changes. The chart below depicts the market cap breakpoints of how KOMP is currently constructed versus if it were market cap weighted. Additionally, the overlap analysis from earlier – where only 24% of KOMP’s weight was made up of S&P 500 stocks – significantly increases, to 70%. Lastly, the measure of differentiation changes to the S&P 500 Index, as measured by active share – the percentage of stock holdings in a portfolio that differs from a benchmark index. The real KOMP has 85% active share, while a market cap-weighted version has only 64%.

Weighting can have serious impact, and when targeting thematic trends where idiosyncratic or firm-specific risk can be elevated — as not all firms innovate successfully — a diversified investment approach that is non-market cap-weighted is optimal. Non-market cap-weighted funds may allow investors to participate in these generational trends without shouldering sizable single-stock risk.

Adding disruption to portfolios

From an implementation perspective, when seeking to add disruption to core portfolios, the goal should be differentiated NextGen-type exposure. Otherwise, the impact may not be what was intended, but rather the addition of a traditional exposure with a fancy name.

To illustrate the notion of seeking to add differentiated disruption, we can analyze active share of a portfolio that is split 80/20, where 80% is allocated to traditional market cap exposures — from large to mid to small — and 20% allocated to KOMP.

The new 80/20 portfolio has an active share of 17% compared with the traditional market cap only. Given that the active share is commensurate to the 20% weight of KOMP illustrates that the stocks added to this portfolio through KOMP lead to a differentiated profile — as intended. Based upon an investor’s risk profile, the percentage of KOMP can be adjusted. And no matter the allocation (e.g., 60/40, 70/30, 90/10), the active share is commensurate to the weight of KOMP.

Focus on innovation

As reopening and rebuilding begin, new industries will be created and current ones will work to adjust to a new sociological paradigm. This inflection point may present opportunities that are not currently well represented in traditional market exposures. Understanding which ETFs are part of a NextGen trend, how their innovative portfolios are constructed, and their impact when including within a broader allocation are all key considerations when seeking to harness the societal change we are witnessing — and will likely witness for generations to come.