How the Innovation Factor Can Help Both Portfolios and Economic Growth

On last week’s episode of the “Behind the Markets” podcast, Liqian Ren and I had a broad discussion focused on innovation in finance.

First, Chris Jones, CIO and Executive Vice President of Investment Management at Financial Engines, joined us to share his views on the field of retirement planning. Financial Engines manages over $200 billion of assets and is the largest registered investment advisor (RIA) in the country.

Later, Anne Marie Knott, author of the book, “How Innovation Really Works: Using the Trillion-Dollar R&D Fix to Drive Growth,” discussed a new investment factor focused on measuring innovation in companies, highlighting a metric she believes could both create excess returns in stock portfolios and revitalize economic growth.

Financial Engines: The Early Robo

Looking for more entrepreneurial work, Chris Jones made a switch from his career in litigation consulting to become the third member to join Financial Engines back in 1996. He was initially tasked with building a team around its founder, Nobel Laureate William Sharpe, to develop implementation of automated investing for individual investors.

In 1998, they launched their first array of services to provide personalized investment advice in 401(k) plans, primarily for individuals. This service, now known as the Robo-Advisor, provides greater access to low-cost, non-discretionary, professional investment advice for the growing population of retirees.

Initially, the product was sold to Fortune 500 companies that would offer it to their extensive employee bases. In 2003, Financial Engines started offering managed account services more directly, where a client would delegate the responsibility of managing assets to Financial Engines for a small fee. This proved to be wildly successful; helping the company become the largest independent RIA in the country today, with $202 billion in assets under management (AUM).

Financial Engines believes very much in passive investing and utilizes about 75% passive solutions, but has 25% active solutions as well. Jones believes passive investing tends to outperform active solutions, but the markets aren’t perfectly efficient and active management can provide value in some cases. Above anything, Financial Engines targets low-cost investing for its clients, which has driven it away from active strategies and toward low-cost passive products over time.

Jones notes Financial Engine’s ability to offer advice to clients in a variety of ways, from interacting strictly online to talking with an advisor through a call center to sitting down with an advisor who will get to know each client personally. He highlights their ability to tailor investment strategy and advice to each individual client. Financial Engines can service any person with any sum of money at any stage of their life for any given investment horizon. Quality and tailored investment advice previously available only to fewer, wealthier investors is now provided to a much larger range of people.

The Innovation Factor

A few years ago, Anne Marie Knott approached companies to utilize a new metric she created called the Research Quotient (RQ), a vertical measure that captures research & development (R&D) productivity and predicts growth and market value.

Knott sees R&D levels as a key measure of innovation in a company, but it is generally hard to value accurately.

Knott’s research shows a 65% decline in companies’ RQ over the past four decades, and she sees this decline as correlated with economic growth. She believes if she can do her part to help restore companies’ RQ, then we can revitalize economic growth, drawing inspiration from Paul Romer’s growth theory that won him the Nobel Prize in 2018.

At a high level, RQ measures output elasticity of R&D, which indicates how much sales are generated in response to increasing levels of R&D. RQ can be broken down to the percentage increase in revenue that comes from a 1% increase in R&D. 

Knott’s research showed that a portfolio of high-RQ stocks outperformed the market substantially, having twice the predictive power of the momentum factor. This would make RQ one of the more powerful predictors of excess returns.

This conversation was one of the more unique, quantitative, factor-driven discussions we’ve had on the show, with broad implications for both the economy and long-term stock portfolios.

To listen to our full conversation, please see the link below.