ARK Invest Update
The purpose of this article is to provide you with an update on the much-discussed ARK Invest actively-managed ETFs as of January 14th 2022. I have written about ARK Invest and its founder Cathie Wood twice in the past in E-MorningCoffee, and you can find those articles here:
Even as I was penning the first of these articles in early March 2021, the shine was starting to come off of the market for disruptive technology companies, dragging the actively-managed ARK Invest ETFs down with them. The issue, which seemed clear even then, was not that Ms Wood and her team had necessarily chosen bad companies, but rather that the stocks of most of these companies – many not yet profitable – were significantly over-valued. Investors in ARK ETFs (and directly in many of the underlying high-flyers) lost sight of value, which seemed to matter little in the early stages of the pandemic as it was a time of free flowing fiscal stimulus and a highly accommodative Federal Reserve. FOMO, or the “fear of missing out”, was too much for many investors to bear, especially ones with a short history of investing in equities. Making money with the likes of ARKK and high-flying stocks became too obvious and easy early on, but as is often the case, these trades became increasingly crowded. Once this happened, over-valued stocks became vulnerable to sentiment flattening out and then turning sour. Indeed, history has shown time and time again that reality eventually seeps back into investor psych for one reason or another, causing asset bubbles to deflate. This is just what happened to many high-flyers starting in February 2021. Once it began, the trend towards shedding expensive momentum stocks continued through the rest of the year and has accelerated more sharply in the early days of 2022.
The purpose of this article is not to take a shot as Ms Wood, her team or her strategy. To the contrary, she has established a series of actively-managed ETFs that remain popular even today amongst investors, and her team’s ability to identify macro-trends and disruptive companies that can benefit from these trends has been reasonably good. However, good companies and good returns on stocks are two different things, especially when a stock’s value gets wildly out of line with its future cash flows. Make no mistake – this happens on the upside and the downside, which will inevitably be the case during this cycle, too. Although investors seemed to be getting a grip on the downturn of high flying stocks as 2021 wore on, the unexpected and rather harsh hawkish tilt in the Fed’s stance in late November caused yields to become more volatile and to head higher, especially at the short end of the curve. This created havoc for shares of high-flyers that tend to be fairly sensitive to higher yields.
Even though Ms Wood is at times too confident for my taste, I cannot fault her for a lack of commitment to her strategy and for the transparency of her firm. She has an unwavering belief in the merits of investing in disruptive companies and the superior long-term returns that such investments will generate. Perhaps there is merit to this argument but it depends very much on both the quality of the company and the entry price. During the year, she showed foresight and made some good decisions. ARK exited Chinese tech stocks (perhaps a bit late) as the “x-factor” of the Chinese government crackdown on domestic tech companies intensified. She also sold Zillow once the company nearly self-destructed by drifting outside its core brokerage strategy. And she sold Tesla shares – ARK ETFs’ largest holding – throughout the year and, as we know now, generally into strength. The ARK Invest website is here, and it is very good because it is loaded with information about each fund. The website also offers a variety of support resources. Investors interested in the ARK family of ETFs can sign up to receive an email each evening after the market closes to see the trades that each of the five major ETFs did that day. Although this information might be considered slightly dated by the time it is received, it nonetheless provides interesting insights into some of the macro trends and thinking of the ARK Invest investment committee.
With this context, let’s look first at the trend in returns of the ARK Invest ETFs.
As you can see, 2020 was an exceptional year for the ARK ETFs with all five flagship funds significantly outperforming both the NASDAQ 100 and two technology-related (passive) ETFs, the XLC and the XLK. The periods before 2020 were not dis-similar – many of the ARK ETFs soundly outperformed the more diverse indices and technology sector funds. The ARK ETFs are fairly concentrated, with the top 10 positions of each ETF accounting for between 50% and 60% of total AuM. As such, each ETF is highly beholden to the performance of its top few holdings, a topic that I will discuss more thoroughly below. From a return perspective, you can see in the table above that the fortunes of the ARK Invest funds changed in 2021, with all of the funds (save ARKQ) negative on the year whilst the NASDAQ 100 served up a 26.6% return. So far in 2022, the returns on ARK Invest ETFs have been around three times worse than that of the NASDAQ 100 and the broader technology sector ETFs. Since the beginning of 2020, the flagship ARKK ETF (largest AuM) has underperformed the broader NASDAQ 100 over the same period.
With a focus purely on high-flyers, the deterioration in value of these stocks has caused the AuM of the ARK Invest ETFs to decline significantly, which you can see in the table below. The dates I have included in the table are: the end of 2020, the year that the ARK ETF delivered outsized returns; on Feb 12th 2021nwhen many high-flyer stock prices peaked; in mid-May 2021 when I wrote a follow-up article about ARK; and last Friday, Jan 14th.
AuM of these six ETFs is now less than half the AuM at the time that most of the current crop of disruptive companies hit their peaks in early February 2021. It is important to note that the large decline in AuM is not so much attributable to investors exiting the funds, but rather to the sharp drop in stock prices of the underlying holdings. Remember that the ARK Invest funds are ETFs which are actively traded on the NYSE. Selling the shares of an ARK ETF does not require the fund manager (ARK Investment Management) to sell the underlying shares in the fund, as such liquidations in the ETF only occur when there is an arbitrage between the NAV and market value of the ETF in question.(1) Therefore, the AuM deterioration of ARK ETFs has been mainly caused by the decline in prices of portfolio companies. The “ETF Database” website, which you can find here, provides investor flows into and out of each ETF as units are created and destroyed. If you search on the ETF by ticker – for example ARKK – you will find a tab, labelled “Fund Flows”, on the left side of the page. This website, for example, shows that ARKK had outflows of $828 million in the last month, which makes me conclude that genuine outflows are intensifying as portfolio values decline more aggressively.
The table below shows the returns over various periods of the top five positions in ARKs five ETFs by percent of total AuM – TSLA, TDOC, COIN, ZM and ROKU. I have included prices and returns using Feb 12th 2021, as this was considered the peak or near-peak prices of most of these stocks, with TSLA obviously being the exception.
As you can see, the “star” of the ARK Invest ETFs – and the only company to show resiliency in the face of a harsh correction in stocks of high-flyers over the last 11 months – has been TSLA. On March 9th 2021 (the earliest date for which I had data handy), TSLA was approximately 8.1% of the AuM of the ARK ETFs. By Jan 14th 2022, TSLA had decreased to 6.5% of total AuM, even though the price of the company’s stock had increased significantly during this period. The next four holdings below TSLA – TDOC, COIN, ZM and ROKU – have declined sharply since the peak of high-flyers around Feb 12th 2021 (and COIN since its IPO in April 2021). TSLA’s amazing appreciation both turbo-charged returns of the ARK ETFs during their pre-February 2021 run, and similarly blunted the negative impact of returns of the ETFs since then as other high-flyers were selling off sharply.
Let me turn back to the decline in AuM of the ARK ETFs. Even though the actual outflows from the ARK ETFs have been modest (since most of the change in AuM has been related to changes in prices of stocks in each ETF), the amount of AuM is of course important to ARK because it is the driver of the investment firm’s revenues. ARK Invest’s management fee is 0.75% of the AuM, very rich compared to most ETFs (which are passive anyhow). As AuM declines, revenues decline and margins compress. Ultimately, this has an effect on the level of operating costs that the firm can bear. I believe that much of the operating cost base of ARK Invest likely consists of compensation for the supporting team of analysts. I have not read about ARK Invest reducing its cost base, but I would not be surprised to see this occur in the coming months should AuM continue to shrink. This, in turn, could have a knock-on effect on the number and quality of the firm’s analysts charged with identifying the disruptive companies of the future.
I mentioned earlier that holdings in the ARK Invest funds are relatively concentrated. You can see this in the table below, which is populated by names that you will most certainly recognise.
As already discussed, the ARK ETFs have had a very rocky performance now for nearly a year, and this has caused the AuM to shrink significantly. Even so, the firm has remained firmly anchored to its overall strategy of investing in disruptive companies, and its operating model has not changed, at least not visibly and not yet. Perhaps the funds will eventually get oversold on the downside, much like they were overbought on the upside, although I expect there is more risk still that prices of high-flyers will fall further before they stabilise (and eventually increase), especially given current sentiment. If you do not find ARK ETFs interesting even at these significantly lower levels (than one year ago), the ARK funds – especially the relatively liquid ARKK – is an interesting way to play the short side of disruptive tech stocks, should you believe that these companies are still generally over-valued. Also, buying puts on ARKK offers an imperfect, but not unreasonable, hedge should you own some disruptive company stocks in your portfolio.
It has been a rocky road for the ARK ETFs, as returns have been much poorer for the last 11 months or so than the market at large, just like they were wildly better during the heydays of high-flyers. AuM has fallen dramatically as a result. Should investors ultimately turn against ARK ETFs and its portfolio of high-flyers, the effects might ultimately be much more dire for ARK. As it stands, Ms Wood is continuing on her mission although as we know from history, outlandish returns are associated with outlandish risk. This is the simple reality that was lost on many investors, some of whom had blinders on as they piled indiscriminately into money-losing tech companies with no concern about or interest in long-term fundamentals. Ms Wood’s aura is falling most certainly as conditions worsen, but she still has plenty of believers. I have little doubt that at some point – and it is certainly not yet – the sell-off will become overdone. When this will occur though is anyone’s guess given the context of where we stand at the moment as pandemic-related accommodative fiscal and monetary policy unwinds.
(1) This is a topic I covered in some several prior articles on ETFs, the most relevant of which is “ETFs and Passive Investing” written Feb 19th 2020.