Are there portfolio-spanning implications of technological change?
A new PGIM white paper — “The Technology Frontier: Investment Implications of Disruptive Change” — suggests that investors should rethink their approach in response to technological disruption.
“The impact of artificial intelligence, autonomous vehicles, augmented reality, and other disruptive technologies are just beginning to be felt — but whether at the macroeconomic level or within individual industries, the implications for investors’ portfolios will be profound,” the report states.
As these advances become more deeply integrated into the global economy, investors will need to carefully evaluate their assumptions around economic growth and industry concentration; opportunities and risks in both digital and real-world industries; and their portfolio’s overall exposure to the firms poised to capture the benefits of, or fundamentally at risk from, technological change.
PGIM believes long-term institutional investors should evaluate five possible actions to “reap the benefits and avoid the risks of the current wave of disruptive technologies.”
1. Position the portfolio for growing obsolescence risk.
As people are living longer, investors are facing pressure to further lengthen the duration of their investments. The low-yield environment post-crisis has also put pressure on investors to reach for additional yield by lengthening loan duration.
“While lengthening maturities is not a new phenomenon, today’s unprecedented pace of technological change can exacerbate the risks investors must weigh when making long-term buy-and-hold debt investments or illiquid investments in private assets, real estate or infrastructure,” the report states.
According to the report, those risks can include whether or not a firm survives long enough for a successful exit or to repay their debts. As an example, the report points to Eastman Kodak, which issued $250 million of eight-year duration senior secured bonds — $50 million more than originally planned — less than 12 months before the firm filed for Chapter 11 bankruptcy.
The report suggests that chief investment officers consider forming a cross-asset-class team to evaluate the impact of technological change across all their holdings.
PGIM also says that long lockup or long-duration investments (in particular those with credit portfolios — where investors may bear the risk, but not the upside, of technological change) may require a closer look to build in adequate safeguards given the fast pace of technology driven disruption, according to the report.
2. Develop an investment framework to identify technology-driven leaders.
Going forward, PGIM believes the select subset of firms able to integrate technology to create lasting competitive advantage and high earnings growth will be the ones driving a disproportionate share of investment returns.
According to PGIM, the key is not to bet on the companies in a sector or geography, but to proactively identify these higher probability technology-driven winners early on.
Though this might require investors to invest in several firms initially, the goal is to steadily consolidate positions into the likely winner.
PGIM outlines five characteristics that it thinks investors should track in order to find the companies that are well-positioned to succeed.
- Firms that can capture network effects in their product offering.
- Firms that disproportionately invest in research and development, especially in proprietary mission-critical IT systems that others can’t replicate.
- Firms that actively supplement in-house tech development with technology-driven M&A.
- Firms that consciously structure their business models around the adoption of technology.
- Firms that disrupt new markets with defensible business models.
3. Look beyond venture capital to capture technology-driven investment opportunities
After identifying technology leaders, investors will then need to work with their in-house teams or asset managers to figure out the optimal vehicle to access these investment opportunities.
This is not purely a conversation about startups and disruptors; instead, investors will need to broaden their lens to ensure that opportunities are captured across a wide range of access points and investment vehicles.
While asset owners have used venture capital investments to access new technology, as a whole the VC space may not always be the best way to do so, according to the report. The report points out that, on average, VC has delivered both the highest risk and lowest returns – averaging only 3% returns and generating effectively zero net alpha since 2000.
The report notes other areas investors could consider. For example, the physical and digital infrastructure enabling the rapid growth of technology is one area for investors to consider.
Another area to consider is “the large number of scaled technology companies that have chosen to remain private and are developing cutting-edge technologies away from the glare of the public eye,” according to the report.
This is a growing pool. According to the report, late-stage investments represented nearly $60 billion in the second quarter of 2018, up nearly 150% from a year ago and accounting for nearly two-thirds of global venture investments that quarter.
4. Evaluate how alternative data and predictive analytics are being used by fundamental managers.
According to the report, predictive analytics, big data and machine learning could have important implications for fundamental managers, and ones that institutional investors will want to consider carefully.
Whether applied to public or private portfolios, investors need to be thinking about ways that alternative data and predictive analytics can potentially help them identify new sources of alpha. As these tools become more commonplace, effectively integrating them into the portfolio management process will become key.
Asset owners may want to spend time with their fundamental managers understanding if, where and how they expect to incorporate alternative data and predictive analytics into their investment process. Specifically, chief investment officers might want to add a section on technology preparedness in their request for proposals or due diligence agenda when evaluating fundamental managers.
5. Brace for a “techlash.”
Investors will also need to incorporate the regulatory environment into their evaluation of new technologies and opportunities, the report notes.
As these cutting-edge technologies continue to emerge, governments will again play a role in determining which succeed and which fail.
“The light or outdated regulations for many technology companies has led to several technology-centric firms aggressively taking advantage of limited local rules and regulation in a bid to win customers, reduce tax burdens and outmaneuver governments,” the report states.
Uber and Airbnb were earlier adopters of this tactic. Some of these earlier adopters — like HR benefits provider Zenefits, which actively designed software to evade state licensing requirements — have “spectacularly, and publicly, flamed out” as a result, according to the report.
As governments attempt to tighten regulation, technology firms could face significant regulatory uncertainty.
The report also notes that even technologies explicitly designed to operate outside of governments’ reach — most notably Bitcoin — raise numerous legal and regulatory challenges for their users.
“Regulators’ decisions of how to respond to these issues will shape the emergence of the technology for years to come — and investors will want to monitor both policymakers and the lobbying organizations that are seeking to influence the debate,” the report states.
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