The Gavekal Knowledge Leaders Indexes: Capturing the Excess Returns of Highly Innovative Companies

Abstract

In our first white paper, “The Knowledge Effect: Excess Returns of Highly Innovative Companies,” we identified a market anomaly that leads to persistent excess returns among highly innovative companies. We offered two explanations why companies that share a common risk factor — the Knowledge Factor — historically generate excess returns. First, the introduction of the semiconductor has enabled humankind to multiply its intellectual strength in a similar way that the steam engine and electric motor enabled humankind to multiply its physical strength. Corporate knowledge production takes the form of investment in research and development (R&D), advertising and employee training. Corporations spend more on knowledge than they do on property, plant and equipment. The second important root for the Knowledge Effect is the dearth of information about corporate knowledge activities that has been amplified by the poorly timed implementation of conservative accounting practices at the start of the greatest period of knowledge production in human history. This information deficiency has led investors to make a systematic error in the way they assess the prospects of companies that invest significantly in knowledge. Ultimately, this systematic error is reflected in a persistent risk premium, or excess return, for companies that invest significantly in knowledge.In this second paper, we describe our process of creating the Gavekal Knowledge Leaders Indexes. These indexes are designed to capture companies that share a common risk factor: knowledge intensity. We begin with a history and discussion of index construction schemes. Next we review how and why we created our own Gavekal Capital International (GKCI) Indexes to serve as the selection universe for the Gavekal Knowledge Leaders Indexes, comparing and contrasting our methodology with Morgan Stanley Capital International (MSCI) Index model. From there, we discuss how we adjust company financial statements for knowledge investments and outline the rules we use to identify the companies in our flagship Gavekal Knowledge Leader Indexes. We follow with a detailed review of the performance and risk history of each index, comparing and contrasting with the MSCI Indexes. We conclude with a factor based decomposition of the Gavekal Knowledge Leaders Indexes which quantifies the alpha specifically attributable to the Knowledge Factor.