Submitted by Nick Colas of Convergex
ETFs And The Pricing Of Disruptive Innovation
Consider the following fact: US listed ETFs own 2.8% of electric carmaker Tesla’s common stock, but 5.1% of GM’s equity and 5.2% of Ford’s shares. Why the discrepancy? One simple reason is that Tesla is not in the S&P 500 but both Ford and GM are. But even when a notionally disruptive company is in a large index, there are still differences. For example, US ETFs own 5.3% of Amazon’s shares outstanding, but 8.8% of Macy’s, 8.3% of Best Buy’s, 8.6% of JC Penney’s and 11.7% of Kohl’s. Another case study: ETFs own 10.9% of the New York Times’ public equity but only 5.1% of Google’s, 5.6% of Netflix, and 5.4% of Facebook’s stock. Our catalyst for mentioning this today: at some point this week, there will be 2,000 listed ETFs on US exchanges (1,999 as of Friday).
Our admittedly anecdotal look at the data makes us ask: “Do ETFs own too little disruption, or will they push a rotation to value stocks as they continue to grow?” For our money, it’s probably the former and this observation shows a path to active manager outperformance relative to the common indices that ETFs track: own as much disruption as you can.
The growth of exchange traded funds in US capital markets is a textbook case study in “Disruptive Innovation”, right alongside well known historical examples like Amazon, Google, Facebook, Netflix and scores of others successful enterprises. It has been a little while since we’ve written about the concept, so let’s review:
- Harvard Business School professor Clayton Christensen codified the notion of disruptive innovation in a 1995 article for the Harvard Business review and a subsequent book, “The Innovator’s Dilemma”, published in 1997.
- The essential idea is that “Disruption” enters an industry at the low end of a product range. A new competitor figures out how to offer a price-competitive budget offering through the use of some new technology or business model (or ideally, both).
- At first, the successful companies in an industry ignore this new entrant. After all, they don’t make much money at the low end of the product suite anyway. Ceding that ground to the upstart actually improves their profit margins and return on capital.
- Then, the new entrant starts to take market share in the middle market, and then finally at the high end. Their initial success (and better profits) at the low end fund this advance.
- If this concept feels familiar, that’s because it is the playbook for much of the current venture capital cycle. Take a bit of technology, figure out an existing market it can disrupt, and unleash it to the world. As long as it follows the “attack the low end and climb from there”, it has a fighting chance of success.
- If you haven’t read the original Christensen article or the 2015 follow up in HBR, click here for the latter (and there is a link to the former in the first sentence): https://hbr.org/2015/12/what-is-disruptive-innovation
The growth of US listed exchange traded funds over the last +20 years follows Christensen’s paradigm almost exactly. At first, there were just a handful of products (SPY and QQQ are 2 of the oldest) and they were designed to replicate plain-vanilla equity indices – the low end of the money management product suite. Over time, the ETF industry expanded into other products: fixed income, commodities, real estate and energy trust investments, hybrid and futures based offerings.
As a result of this growth, sometime this week the 2,000th exchange traded fund will list on a domestic exchange. It is no exaggeration to say that there are more ETFs than investable stocks listed on US exchanges. There aren’t 2,000 stocks in the 3 most widely followed S&P indices (1,500 there). And there aren’t even 2,000 stocks in the Russell 2000 (which has 1,954 positions currently). Don’t ask – I don’t really understand that second one either.
While watching the coverage of electric car company Tesla’s new highs on Friday, I got to wondering how the disruptive innovation of ETFs gets along with companies that exhibit disruptive traits in their own industries. Forget for a minute about Tesla as a stock to buy or sell (we don’t cover stocks here, so we have no opinion). The question is: “Do US Listed ETFs (as a disruptive agent in their industry) own a lot of TSLA relative to the companies notionally being disrupted?”
Or, in layman’s terms, “Do ETFs own more TSLA or GM/Ford?” The answer (with data courtesy of www.xtf.com, where you can look up any individual equity to see which ETFs own it and in what quantity):
- TSLA: 92 US listed ETFs own at least 1 share of the company. Collectively these ETFs own 2.8% of the shares outstanding.
- GM: 157 US listed ETFs own GM, and in total they hold 5.1% of the company’s shares outstanding.
- Ford: 156 US listed ETFs own Ford, in total holding 5.2% of the company’s shares.
- American Axle: owned by 62 US listed ETFs, with 12.9% of shares outstanding.
- Goodyear Tire: owned by 126 US listed ETFs, with 6.8% of shares outstanding
- BorgWarner: owned by 129 ETFs, with 6.4% of shares outstanding
On average, therefore, US listed ETFs own almost twice as much (or more) exposure to the “Old auto industry” than “new auto industry”. Now, if Tesla ends up flopping that could be fine. But if Tesla does end up rewriting the rule books for the light vehicle industry, then the average ETF investor will end up owning too little of the winner and way too much of the losers. Only time will tell which is right, but that’s the math today.
Another simple example: Amazon versus predominantly brick and mortar retailers. Here is the data, again from www.xtf.com :
- Amazon: owned by 178 ETFs holding 5.3% of the company’s shares outstanding
- Macy’s: owned by 146 ETFs, with 8.8% of the shares out
- Kohl’s: 161 ETFs, with 11.7% of shares outstanding
- Wal-Mart: 185 ETFs, with 6.4% of shares out
- Target: 184 ETFs, with 7.0% of shares out
- Ralph Lauren: 113 ETFs, with 6.9% of shares out
This case study is a little more apples to apples than Tesla, which is not in the S&P 500. Amazon obviously is, and yet invariably ETFs own more of the traditional players than the disruptor as a percentage of market cap. Like Tesla, if Amazon starts to stumble that could prove to be the right answer. But for now, the average ETF has a larger stake in the typical brick and mortar store than Amazon.
As a last case study, we have to admit that the paradigm of what tech company is disrupting which industries is not always clear. Still, consider the following ETF ownership percentages:
- The New York Times: 65 ETFs own a total of 10.9% of the market cap.
- Time Inc: 75 ETFs own 11.2% of the market cap.
- Meredith Corp: 95 ETFs own 27.1% of the market cap.
- Google/Google “L”: owned by 151/163 ETFs, with 5.1%/5.2% of shares out.
- Netflix: owned by 146 ETFs, with 5.6% of shares out.
- Facebook: 188 ETFs, with 5.4% of shares out.
From this limited sample, ETFs do seem to overweight some “old media” relative to a variety of newer disruptors. Will this prove smart? Only time will tell.
The sharp-eyed reader will probably retort: “This whole thing is not really about ETFs. It is about the indices that the ETFs track.” And that is right, to a point. But it is also about how ETF product development and money flows drive the pricing of equity assets.
From our examples today, it does seem like the ETF ecosystem (flows plus index weightings) tends to be naturally long companies in the crosshairs of disruption and short those doing the disrupting. As I have said – but it bears repeating – there is nothing wrong with that. It may work. Or it may not. But it is important to know.
Back when Steve Jobs and Apple invented the iPad, there was a joke that if he had chosen to release a product made of paper sheets glued into a binding and printed with indelible ink, people would have stood on line to buy that too. Even though, of course, it would just be a book. Such is the nature of innovation – it is unpredictable because it lies at the intersection of human taste and technological advancement. Neither is entirely predictable, and taken together even less so.