ETF Expert Corner

Bryce Coward Spotlights the Knowledge Leaders Developed World ETF (KLDW)

July 17th, 2018 by ETF Store Staff

Bryce Coward, Portfolio Manager & Deputy CIO at Knowledge Leaders Capital, explains the “knowledge effect” and spotlights the Knowledge Leaders Developed World ETF (KLDW).


You can listen to our interview with Bryce Coward by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: The ETF we're spotlighting this week is the Knowledge Leaders Developed World ETF, ticker symbol KLDW, and joining us via phone from Denver, Colorado to discuss this ETF is Bryce Coward, Portfolio Manager and Deputy CIO at Knowledge Leaders Capital. Bryce, thanks for joining us today.

Bryce Coward: Hey Nate, thanks for having me.

Nate Geraci: Bryce, so this ETF attempts to capture what you call the knowledge effect and I thought before we delved into the ETF itself, it would probably be helpful to have you first provide some background on exactly what this is. So how do you explain the knowledge effect to investors and why is it important?

Bryce Coward: Great question. So the knowledge effect - it's a market anomaly of behavioral bias much like the value effect or the small cap effect whereby highly innovative companies outperform the stock market on a total return and risk-adjusted basis. And it all comes back to this idea that our accounting standards don't really treat innovative investments the same way as the accounting standards treat investment and physical capital like property, plant and equipment. So think of innovative investments with anything like research and development, software development, development of a database, teaching employees how to use software, things of that nature. And so, ironically, the accounting rules changed in 1974 just as the tech revolution was getting going. And those changes required companies to expense all investments in innovative capital in the year in which they were incurred. So think of a company like Intel doing a bunch of R&D, having to take that R&D expense through their income statement in the first year it's incurred, rather than having it sitting on their balance sheet as an asset so investors can see the size of the asset and determine a cashflow stream from that asset. So investors are sort of deprived of that opportunity because of how our accounting standards are set up. And so what ends up happening is that earnings of highly innovative companies look abnormally low, assets of highly innovative companies look abnormally low, and the cash flow statement confuses investing cash flow with operating cash flow. And so analysts have a very, very difficult time understanding the earnings potential of highly innovative companies and so this results in a market anomaly whereby these companies just tend to systematically outperform the market.

Nate Geraci: So how is this knowledge capital measured? In other words, how do you identify a highly innovative company?

Bryce Coward: That's a great question. So we have a proprietary process that we've developed to basically readjust financial statements to account for all of the intangible investment that takes place. So, think of a company that does a bunch of R&D, like Intel as we just mentioned. So, instead of having that R&D be expensed through the income statement in year one, we have a proprietary process whereby we go through each developed market company in the world, about 2000 companies, and we're able to identify intangible investments and capitalize them or treat them in the exact same way that we are treating investments in physical capital. So our adjusted financial statements we think reflect economic reality for these businesses more so than traditional reported financial statements. And so with these financial adjustments and financial statements, we're then able to go through and identify the most innovative companies in the world based on a proprietary process and a series of metrics that we can talk about later that inform us which companies are the most innovative.

Nate Geraci: Earlier you mentioned a comparison with something like value or small cap. So it sounds like you do consider knowledge a factor - that we're talking about academic studies here and the potential for companies to outperform. So is that correct, you view this as a factor?

Bryce Coward: Yes, I think that's exactly right. So if you go back and you look at the academic research on factors, the idea is that there's only a couple of them that tend to be persistently accretive to alpha in a portfolio. You've got the small cap factor, the value factor, the momentum factor, the low volatility factor. So there's only a handful of factors out there that people really pay attention to that have shown a persistence in the market to work. What we've seen, when we have delved into those factors is that, yes, while they do tend to work over very, very long periods of time, the performance tends to be really choppy. So sometimes they work, sometimes they don't work. You never really know in what market environment they're going to work in. And so that makes factor investing kind of difficult for investors, because they're not really buy and hold strategies because it’s sort of like a binary on/off switch when they're going to work and when they aren't going to work. What we've seen with the knowledge factor, and in contrast to that, is that there's a greater persistence of outperformance and a much greater consistency to it. So yes, we think it's a behavioral anomaly just like those other factors, but it just tends to work a little bit better and be a little bit more appropriate for a buy and hold investor.

Nate Geraci: Alright, so let's talk about the ETF - the Knowledge Leaders Developed World ETF, again, ticker symbol KLDW. Take us through the methodology here.

Bryce Coward: So, as I mentioned a couple of minutes ago, what we do is we adjust the financial statements for all developed market companies. So this covers about 2,200 companies across 22 developed market countries, and we look at the top 85% of the market cap in each country. And then, from there, we'll apply a liquidity filter. So if we start with a universe of 2,200 companies, we only want to bring out the most liquid, the most investible of those companies. So right away, we eliminate the bottom 10% of companies based on trading liquidity. And so we're left with about 2,000 developed world companies and we've got adjusted financial statements or adjusted financial data for all of those companies that we've created. And from there, we put those companies through a quantitative screening process whereby we pull out the most innovative companies of that group and we focus on knowledge intensity, profitability and balance sheet strength. And these are all features of firms that are successfully following an innovation strategy. So from those 2,200 companies that we start with, we apply our liquidity filter to get down to 2,000, and then we apply our knowledge leader screening process to get down to about 790 knowledge leader companies that compose our Knowledge Leaders Developed World Index, and that index is equally-weighted, and it's rebalanced twice per year in April and October. And it's got an inception date of April of 2000. So it's got a very, very long track record of rich performance history with which we can go back and measure performance of that index.

Nate Geraci: Could you maybe highlight a top holding or two and maybe walk through the rationale as to why they're included in the ETF?

Bryce Coward: That's a great question. So one company that we've talked about already, Intel. So when we go through and we identify all of the intangible investments that Intel is making, we end up with an asset level that looks substantially different from what most investors see and reported financial statements. So, in reported statements, Intel has about $123 billion in assets. When we go through our adjustments, we find another $42 billion of unaccounted for assets. So these are, to be clear, these are assets that are not on their balance sheet in reported terms, that had been taken through their income statement as expenses. And so investors see all the expenses coming through the income statement, but nothing to account for it on the asset side or on the balance sheet side. So that 34% difference in the asset base of Intel is huge and it really sets up the situation where investors can really get it wrong with respect to what the earnings potential of Intel is. And it just so turns out that Intel has a really, really high gross margin, which is a metric we focus on. It's a symptom of a highly innovative business with a unique asset base that's able to produce a unique product set. They have almost no net debt and they've got a really, really attractive profitability profile. So those are all things that we look at in our screening process. Another company which most folks wouldn't consider in an area of high innovation from a sector standpoint is Lawson. It's a grocery store chain out of Japan. And so, if Intel's got a 60% gross margin, it's a semiconductor company, it's one of the most innovative companies in the world, you'd be surprised to know that Lawson has a gross margin of 63.5%. So this is a grocery store chain with a higher gross margin than a semiconductor company. We compare that to a gross margin of Kroger of 20%, Sprouts has a gross margin of 26%. So how is the grocery store able to achieve such an enormously high gross margin? The reason is because they've spent so much money on really optimizing their supply chain system and developing a really comprehensive suite of private label food. So they've got a unique customer experience where the shelves are always stocked with exactly what the customer needs at all times and they've got a private label food product that just commands significantly higher margin. And, on top of that, Lawson's got a 30% operating cash flow margin, which again is extremely high. And because of this inventory management system that they had developed, they had a negative 70 day cash conversion cycle, meaning they turn sales into cash 70 days before they even make the sale, which is just kind of unheard of. So it's kind of a misconception that innovation takes place in only the tech sector or maybe only in the healthcare sector or something. But really it's broad-based and that's what our ETF is trying to capture - the broad-based innovation across sectors, geographies and market cap.

Nate Geraci: Bryce, we have just a couple of minutes left here. You began to touch on performance earlier and I know the ETF recently hit its three-year anniversary. Clearly, the goal of this ETF is to generate some alpha, generate outperformance. Can you talk at all about performance just in terms of perhaps what the benchmark is here and how KLDW has compared?

Bryce Coward: That's a great question. So since inception through June 30th, which is the longest sort of period performance we can talk about here, KLDW has returned 11.27% on an NAV basis, versus the MSCI World Index which has returned 8.74%, and the average fund in the Morningstar World Stock category has returned 8.06%. So the average fund - world stock fund - has actually underperformed the benchmark by about 70 basis points. On an alpha perspective, KLDW has turned in 3.94% alpha versus a zero for the MSCI World Index, the benchmark. And the average fund in the Morningstar World Stock category has generated negative 78 basis points of alpha over that nearly three-year period.

Nate Geraci: 60 seconds left. How should investors think about KLDW in the context of a portfolio? Where does this ETF fit?

Bryce Coward: KLDW, as opposed to other innovation focused ETFs, is diversified across geographic sectors, and excuse me, across economic sectors and geography. So it's not concentrated in the tech sector or in biotech. And so, because it's diversified, it really is well-suited for a core allocation, for a buy and hold allocation. So an investor might use this in place of another high cost mutual fund or another less well performing ETF.

Nate Geraci: Bryce, excellent spotlight today. Thank you very much for joining us.

Bryce Coward: Thanks a lot Nate, I really appreciate the opportunity.

Nate Geraci: That was Bryce Coward, Portfolio Manager and Deputy CIO at Knowledge Leaders Capital. Again, the ETF is the Knowledge Leaders Developed World ETF and you can learn more about this ETF by visiting