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Why ETF Investors Should Consider Allocating to Innovation

Max Chen

This article was originally published on ETFTrends.com.

Exchange traded fund investors should start thinking of "innovation" as an asset class worthy of its own allocation in a diversified global portfolio.

In the recent webcast, Making the Case for Innovation: Rethinking Traditional Asset Allocation, Renato Leggi, Client Portfolio Manager, ARK Invest, explained that according to ARK's research, the global economy is undergoing the largest technological transformation in history, with notable developments in blockchain technology, genome sequencing, robotics, energy storage and artificial intelligence that could quickly change the way we interact with the world.

However, Leggi pointed out that the average investor may be under-allocated to these innovative growth opportunities. ARK estimates that over the next ten years, roughly 50% of the companies in the S&P 500 Index will be replaced.

"The market easily can be distracted by short-term price movements, losing focus on the long-term effect of disruptive technologies. We believe there is a time arbitrage ARK can take advantage of. We seek opportunities that offer growth over 3-5 years that the market ignores or underestimates," Leggi said.

Leggi argued that ARK Invest tries to target the middle ground between private markets that have been crowded by innovation investors and public markets that have grown increasingly passive. Consequently, ARK believes innovative public companies with forward-looking growth are the most inefficiently priced part of the market.

Passive index-based strategies that typically follow a market capitalization-weighted methodology may miss the mark on innovation as they passively wait for these companies to grow bigger. Meanwhile, analysts may have trouble understanding the technology cost curve. This allows an opportunity for more specialized opportunities that ARK has taken upon to look through cross-sector disruptive innovation themes to capitalize on the convergence of research.

"Disruptive innovation demands an open-source approach to gain a deeper understanding of the convergence and full market potential. ARK uses an Open Research Ecosystem that combines top-down and bottom-up research. It is designed to identify disruptive innovation early, allowing for an organized exchange of insights between the portfolio manager, director of research, analysts, and external sources," Leggi added.

The innovative investment theme also provides portfolio diversification benefits. According to ARK, there is a lower correlation between disruptive technologies than correlation between S&P sectors. The average correlation between S&P 500 sectors is 0.55. On the other hand, ARK has identified five major innovation platforms - blockchain, energy storage, DNA sequencing, robotics, and artificial intelligence - and 14 underlying transformative technologies, and the average correlation between the 14 technologies is 0.26.

These innovative investment ideas may also enhance an investor's equity portfolio. For example, looking at 5-year data ended 2019, a standard portfolio of 60% U.S. stocks, 30% international developed and 10% emerging market produced an annualized return of 14.3% with a Sharpe Ratio of 0.67. In comparison, a portfolio with just 10% innovation, 9% emerging markets, 27% international developed, and 54% U.S> produced an annualized return of 16.4% and a Sharpe Ratio of 0.75.

"Investing in converging innovations and industries offers the possibility to produce outsized absolute and risk-adjusted returns. ARK believes investors should seek to identify stocks poised to benefit from trends not yet fully recognized in the market," Leggi said.

As a way to help investors focus on disruptive innovations, Rebecca Burke, VP, National ETF Sales, Resolute Investment Managers, highlighted options like ARK Invest's flagship ARK Innovation Fund (NYSEArca: ARKK), which seeks to invest in the cornerstone companies taken from healthcare, technology and industrial sectors that focus on investing in disruptive innovation. Such companies may include ones that benefit from big data, cloud computing, cryptocurrencies, the sharing economy, genomic sequencing, molecular medicine, agricultural biology, 3D printing, energy storage, and autonomous vehicles.

For more targeted exposures, investors can look to the ARK Industrial Innovation ETF (NYSEArca: ARKQ), ARK Web x.0 ETF (NYSEArca: ARKW), ARK Genomic Revolution Multi-Sector Fund (NYSEArca: ARKG)ARK Fintech Innovation ETF (ARKF) and ARK 3D Printing ETF (CBOE: PRNT).

Additionally, the ARK Israel Innovative Technology ETF (Cboe: IZRL) provides access to Israeli companies whose main business operations are causing disruptive innovation in the areas of genomics, health care, biotechnology, industrials, manufacturing, the Internet or information technology.

The active strategies aim for a negative correlation of relative returns to traditional value strategies and low correlation of relative returns to traditional growth strategies. For instance, only 1% of S&P 500 Index stocks are represented in ARK's Disruptive Innovation Strategy.

Financial advisors who are interested in learning more about opportunities through innovation can watch the webcast here on demand.

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