Another case study: ETFs own 10.9 percent of the New York Times' public equity but only 5.1 percent of Google's, 5.6 percent of Netflix and 5.4 percent of Facebook's stock. Our catalyst for mentioning this today: At some point this week, there will be 2,000 listed ETFs on U.S. 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 U.S. capital markets is a textbook case study in "disruptive innovation," right alongside well-known historical examples like Amazon, Google, Facebook, Netflix and scores of other 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.
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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 rule "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, there is a link to the former in the first sentence.
The growth of U.S.-listed exchange-traded funds over the last 20-plus years follows Christensen's paradigm almost exactly. At first there were just a handful of products (SPY and QQQ are two 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.