Best Sectors for Innovation Exposure

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Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Ryan Diamant, Client Portfolio Manager, Equities, CIBC Asset Management.  

So, some of the major themes we’ve observed within innovation over the last 18 months.  

Well, certainly the first one would be the Magnificent Seven. Companies like Nvidia, Apple, Alphabet, Microsoft, they had a stellar 2023, and then some of them continued their performance into 2024. So, they’re a closely watched group of technology companies, which have really gained a lot of interest.  

The second theme would be artificial intelligence. It has the potential to change our day to day, the way we work, and it’s really easy to adopt. All you need to do is speak in your native language, and you get data or information that you’re looking for. So, we see more potential to come.  

And another trend has certainly been electric vehicles. There is certainly a shift from the combustible engine to EVs. And with companies like Tesla increasing the amount of cars they’re producing, we see more potential for EVs.  

But I would also say there’s a long-term trend in play, and many Canadians are under exposed to innovation. Now, there’s a well-documented trend of something called a home bias. And that says that many Canadians have a lot of their wealth tied up in the Canadian market. So, when we look at something like the TSX composite, there are very few dominant technology companies. And the health-care sector is mostly comprised of pot stocks. So, overall, we believe that Canadians have the opportunity to increase their exposure to places like technology and innovation.  

The sectors that provide the best opportunity for investors to gain exposure to innovation would be technology and health care. And when I mean technology, there are two main sectors within that. Obviously, the information technology sector, also the communication services sector, like a company like Alphabet. And these two areas of the market, technology and health care, I would say provide two different exposures.  

So first off, technology provides a little more torque for portfolios, a little more upside exposures. These companies are creating new, innovative and disruptive technologies that create an entirely new market for the companies. Take a company like Nvidia, they supply the chips for artificial intelligence. And there are very few other competitors that are able to catch up. Even a closely watched company like AMD has really been ineffective at releasing products to the ability that NVIDIA has. And so, information tech is all about disruption and upside for portfolios.  

Health care is a little different. It certainly provides growth, but I would say it’s more defensive growth. And if we look at the last five market dislocations or market drawdowns, including the 2022 market drawdown, Covid-19 drawdown, as well as the financial crisis, health care protected in all the last five market corrections. I think the reason behind that is government expenditures, whether it’s in U.S., Canada or other developed markets, is constantly increasing, R&D spending is increasing. There are aging demographics in play in most developed countries. And regardless of whether it’s boom times or bust, unfortunately, people are still getting sick. So, what that means is the health-care sector, because of all those reasons, is constantly increasing, and constantly looking at new innovations and new therapies or drugs. 

When you combine technology and health care into a portfolio, it’s a very interesting result. So, first off, technology provides that upside exposure, and health care actually provides more risk-adjusted returns. And when I say something like risk-adjusted returns, within something like technology, you can take a significant amount of volatility, but you want to be compensated for the risk you’re taking. And so, risk-adjusted returns or something like the Sharpe ratio standardizes the way we look at returns. And so, all of the analysis we did on the team was looking at something like the Sharpe ratio.  

So, when we combine technology and health care together, we looked at all the different allocations whether it’s 90% tech and 10% health care. And what we arrived at is the best allocation was a 60% technology portfolio, 40% health care, and that offered the highest risk-adjusted returns, but also provided enough upside exposure. Because when you are investing in innovation, you want that torque for your overall portfolio.  

And so, when we looked at a 60/40 tech and health-care portfolio, we looked over the last 10 years and looked at five-year risk-adjusted returns, so something like the Sharpe ratio. And when we did that, we saw that a 60/40 portfolio outperformed 100% of the time over the last 10 years, and from a return perspective, outperformed by around 600 basis points, annualized. So, quite significant. But as mentioned, we typically look at the Sharpe ratio, and that had significant outperformance over the last 10 years. And even if you were to look right before the tech bubble in October of 1999, to something like March 31, of 2024, the 60/40 innovation portfolio would continue to outperform broader global equities, and it would do so with better risk-adjusted returns.  

So, when we look at something like the global information technology index, and the global health care index, and compare that to broader global equities, going back to 2009, so over the last 15 years. In both cases, information technology and health care significantly outperform. And as mentioned, technology provides a little more upside and health care protects on the downside, but both outperformed quite significantly. And even if we were to take this lens and go right back to prior to the tech bubble in October of 1999, it’d be the same case with both global technology and global health care significantly outperforming broader global equities over time. 

Why wouldn’t someone just invest in the Nasdaq to obtain their innovation exposure?  

Well, I would say that the Nasdaq has two key drawbacks when investing, and the first component here is that the Nasdaq is designed to provide non-financial company exposure. So, while it does have a significant amount of technology and health care, it’s not true innovation exposure, it does allocate to places like the consumer, industrials, even at times some energy companies. And so once again, it is not true innovation exposure. But I think the number one key drawback related to the Nasdaq is its concentration. And if we look at the top 10 holdings within the Nasdaq, since 2016, the top 10 holdings have accounted for over 50% of the exposure within the Nasdaq, and in some cases, have approached 60%. And when you’re that concentrated, it could create a situation where you’re magnifying returns on the upside and the downside. And I think a recent case study of that, it would be Tesla. Throughout 2023, it was up 102% and was around 4% of the Nasdaq. And just three months later, and Tesla was down 30% and it was around 2% of the index. And I think concentration really works on the upside. It certainly worked in 2023 when the Magnificent Seven was doing quite well. But I think it could magnify losses on the downside. And people invested within the NASDAQ don’t appreciate the risks embedded with having such concentrated exposures.  

And so that’s why we wanted to look at how a 60/40 portfolio of tech and health care performed against something like the Nasdaq. And when we did so, going back to September 15 of 1999, we actually saw that that 60/40 portfolio underperformed from an absolute standpoint. But that did not show the full story. When we looked at both the volatility and the beta, both metrics were around two-thirds of that of the Nasdaq, and the risk-adjusted returns of that 60/40 portfolio were higher.  

And so, what that means is a 60/40 portfolio compensates for risk taking better than something like the Nasdaq.  

It’s really important to go active within the innovation space. And the reason behind that is the way a lot of the most popular passive indices are constructed. Now, especially with something like the Magnificent Seven, a lot of these indices are based on historical returns. So essentially, the companies who have done the best over the last year, three years, five years are the largest weights within these indices. And so, you know, indices are looking at historical returns, but active management is looking at future returns.  

Active management is essentially looking at which companies are going to do best in the future, which ones are going to experience the largest growth? And then making allocations based on that.  

And then passive solutions are just dominated by those concentrated mega cap positions and can be impacted, especially if a lot of those companies fall significantly. And so, I would say that going active is so important, because you’re looking at what’s going to do best in the future. While passive solutions, especially something like the Nasdaq, is looking at what has been the best in the past and it’s a very important consideration when investing.