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Rethinking Asset Allocation - Why Innovation Deserves A Place in Your Portfolio

The Blue Water Team

A new article by ARK Investment Management challenges the traditional "style box" method of choosing portfolio investments, recommending instead that investors adopt a more flexible approach that embraces innovation as part of a diverse portfolio equipped to grow over the long-term. 

In particular, ARK is concerned with the potential changes on the horizon from so-called "disruptive innovation," like digital wallets, which are gaining significant market share when compared with traditional banks. Investors should consider the following facts about these innovative transformations:

  • Disruptive innovation will grow from a $6 trillion presence in the global economy to a $50 trillion presence by 2032.
  • The average lifespan of an S&P 500 stock should drop from 24 years to 12 years by 2027 because of disruptive innovation.

These changes reflect a larger trend: The overturn of traditional industries by new platforms and technologies. When evaluated based on traditional "style boxes" that measure factors like value, blend, and growth, many innovative stocks look like poor investment choices. 

However, the reality is that many innovative businesses are simply using earnings to prepare for explosive growth later on. As a result, savvy investors must maintain the flexibility to add disruptive technologies to their portfolios in order to take advantage of this growth.

This type of adjustment in portfolio allocation has occurred before, in the 1980s and '90s, with emerging markets. While originally overlooked by investors because of their volatility, emerging markets delivered returns greater than those delivered by the developed world.

As with emerging market investments three decades ago, innovative investments today may appear volatile, but actually make promising additions to investors' portfolios. Why? For three main reasons. 

First, as mentioned above, innovative businesses are likely to experience significant growth in the near future. 

Second, innovative stocks have a lower correlation among each other than do more traditional investments. Consider, for example, the fact that the average correlation among the 14 disruptive technologies identified by ARK is just .22, as opposed to the average correlation of .55 among S&P sectors. 

This low correlation means that investors can diversify their portfolios with a variety of disruptive technologies in order to offset the volatility of any one investment. This strategy has already proven effective within the world of emerging markets. 

Third, individuals tend to turn to innovation in times of uncertainty. They want the faster, less expensive benefits that innovation often provides. As a result, innovative technologies could rebound more quickly than more traditional investments. 

ARK sees significantly greater returns on investment for those who add innovation to their portfolios. Among four hypothetical global equity portfolios, the one with the greatest percentage of innovation delivered the greatest results over the past 5 years (at a 20 percent innovation allocation, investors could see an annualized return of 18.6 percent, as opposed to an annualized return of 14.3 percent for a portfolio that does not include any innovation at all). 

Blue Water can build exposure to innovation in portfolios with a variety of ETFs that focus on both broad innovation and themes and more concentrated themes.