ARK Innovation: How To Invest In Cathie Wood's Hyped ETF

Summary

• The ARK Innovation ETF has easily outperformed an already strong equity market in the past several months.
• But I have a few reservations on ARKK and the simplistic investment strategy of merely betting on "the technologies of the future."
• Rather than placing too many eggs in a single basket, I think that a balanced approach to investing in ARKK makes the most sense.
• Looking for a helping hand in the market? Members of Storm-Resistant Growth get exclusive ideas and guidance to navigate any climate. Learn More »

Photo by PM Images/DigitalVision via Getty Images

First, a word of appreciation. Cathie Wood and her ARK Invest firm have been catching the attention of investors and the financial news media over the past year for good reason. A fund like the ARK Innovation ETF (NYSEARCA:ARKK), for example, has easily outperformed an already strong equity market in the past several months.

Also, I believe ARKK is most likely to produce superior returns over the very long run, call it 10 years and beyond, considering the fund's bias toward what will probably be secular winners in the global economy of tomorrow. The firm's website summarizes well the investment strategy, one that I find compelling:

To capture the substantial benefits of new products or services associated with scientific research in DNA technologies, energy storage, the increased use of autonomous technology, next generation internet services, and technologies that make financial services more efficient.

Having said the above, I have a few reservations on ARKK, its investment approach, and the simplistic strategy of merely betting on "the technologies of the future":

• The graph below shows that virtually the entirety of ARKK's outstanding ex-volatility performance has come in the past 12 months alone, since the bottom of the COVID-19 crisis. Take another look at the purple line below, starting in March 2020. The phrase "reversion to the mean" should, understandably, send shivers down the spine of an ARKK shareowner. It is possible that a couple of years' worth of the fund's capital gains, if not more, have been front-loaded through the last nine months of 2020.

Data by YCharts

• More of a sub-bullet of the point above, ARKK thrived in an environment of interest rates that declined sharply toward all-time lows. Due to the high growth, ultra-high valuation profile of the ETF's holdings (see below the astonishing price-to-free cash flow ratios of the top five stocks), the current landscape of rising yields could be a buzzkill for ARK's innovation fund, more so in the short-to-medium terms.
• ARKK's absolute returns have been outstanding since inception: 33% per year vs. the Nasdaq's (QQQ) 21% during the same period. However, returns always should be analyzed within the context of risk exposure. ARKK has endured sky-high annualized volatility of nearly 30% since its late 2014 debut. In Sharpe ratio terms, the fund has actually trailed the risk-adjusted performance of the Nasdaq by a small margin. Exclude the highly atypical COVID-19 period, and ARKK has done even worse than the traditional Big Tech-rich index.

Data by YCharts

How to use ARKK in a portfolio

To reiterate, I'm bullish ARKK. But at the same time, I see plenty of risks to investing in the fund merely as a high-conviction play on trend-right companies and sub-sectors.

For starters, buying ARKK shares immediately following the mind-blowing returns produced during the pandemic year may prove to be bad timing. Also, I'm not yet convinced that a fund like it has proved itself as a market-beating strategy once risk or volatility is taken into account.

Instead, I see ARKK as a valuable piece of a diversified portfolio. Some of the ETF's features that I'm particularly interested in include:

1. The high reward, high risk profile that makes the fund a good complement to more conservative holdings, and
2. What I believe could be low correlations with defensive sectors that might still produce positive returns going forward, but whose path to capital gains will probably not resemble ARKK's whatsoever.

What I'm about to propose below may not sound very appealing to pure-play growth investors "with a vision" for the global economy of the future. But keep in mind that I'm a boring portfolio strategist obsessed with producing more returns per unit of risk. Therefore, I believe the following allocation could prove to be a winner, especially in risk-adjusted terms.

Source: Portfolio Visualizer

• 25% ARKK: Exposure to the right themes in the economy of the future.
• 25% healthcare (IYH): boring, resilient sector of today's economy.
• 25% utilities (XLU): A staple sector producing high and steady income, whose returns tend to be loosely correlated with the rest of the market.
• 25% dividend aristocrats (NOBL): A proxy for treasuries, but with better average yields and, arguably, more upside potential.

A backtest of the portfolio above reveals, unsurprisingly, that it would not have topped the absolute returns of ARKK alone since the fund's 2014 inception. However, the portfolio would have ably matched the ETF's volatility-adjusted performance at a very respectable Sharpe ratio of 1.1.

In addition, compared to the S&P 500 (SPY), the portfolio above would have (1) produced higher absolute returns of nearly 17% per year, (2) beat the market's risk-adjusted performance handily, and (3) faced less destructive peak-to-trough declines.

But to me, more important than past performance is the prospect of future results. Rather than placing too many eggs in a single basket, especially when ARKK seems so richly valued today, I think that a balanced approach to investing in the innovation ETF makes most sense.

Should ARKK rise further from current levels, as I suspect it might over a longer period of time, the model portfolio above would benefit from the climb. Should the ETF correct painfully instead, the portfolio would probably be better protected by its large defensive holdings. In a base-case scenario, I believe that the balanced strategy would still be expected to produce market-beating absolute and risk-adjusted returns.

Analyst’s Disclosure: I am/we are long CALLS ON SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Likrat ha-Tiferet]

...by not buying it?

[phvaessen]

I agree: use AKK as a complement to a more defensive portfolio
I am gradually building up to 20%: 5% each ARKK, AKG, ARKW, ARKX balanced to complement 20% BRK-B and a mix of individually selected stocks like Nvidia(growth) or ABVIE(dividend) and 5% in a gold mine Polyus (I stay away from crypto's, as I have some in the ARK anyway. As BRK-B holds 30% in cash that is also another "passive" hedge.

I think ARK's active research and fund management of 175 disruptive technology stocks gives some hedge too. Not all need to be winners, 100 of them can go bust, ARK only need less than 15 to be ten baggers (or 2 be 100x) and ARK will achieve their objective of 15% CAGR in 5 years.

[Total Returns]

So literally all her gains vs QQQ over the last 5 years are since April of last year? Wow. So it's really just been one killer year?

[DM Martins Research]

@Total Returns That's one way to look at it, yes... Still solid, most active managers can't beat the benchmark. Just maybe not as impressive as many make it sound.

[Qichar]

Why is everyone overcomplicating things? Look, just admit you don't understand technology and stay away from ARKK. I have always been a huge proponent of only buying companies whose business model I understand and believe have a bright future.

This is what people who are so concerned about interest rates and liquidity in ARKK do NOT understand. Cathie knows how to play the long AND the short game. The proof is that her drawdowns were constrained in March 2020 and in the recent February and March pullback of 2021. She buys high float stocks and uses them as cash so she can double down on her high conviction picks during a pullback.

But make no mistake, Cathie has good reason to be bullish long term on these stocks. I am not so naïve as to believe every one of her picks is a winner. But that's why an ETF like hers is convenient: they don't all have to be winners for her fund to do well. I don't have to sit around micromanaging my portfolio composition when I can just let her do it for me. Her time window is at LEAST 5 years, something else all you market timers don't quite get.

So try it. Try timing the market, maneuvering around interest rates, diversifying into other, less awesome companies. Go ahead and be scared of hedge funds trying to break her (lol) when she DOES NOT USE LEVERAGE. If you look at the price action today, her fund is up 4%. Over the last 2 years, all of you market timers would have lost to Cathie's return rates. Ever hear of the expression, "let your winners run, and cut your losers?" There is a reason that works. Stocks that are winning usually correspond to good companies. I'd rather overpay for good companies than pick up crappy companies on discount.

This is also an interestingly timed article after ARKK pulled back from around $160 to $109 recently (where I bought some). I might easily counter with: sell low buy high is not a great strategy.

[Tntowldct]

@Qichar You don't know the whole story behind Ark if you think they are debt free.

When Ark was founded, they partnered with a group called Resolute Investment Managers. Resolute had an option to purchase all of Ark that they tried to exercise last year (at I'm sure what is now a below market deal). Cathie Wood bought them out for an undisclosed price and financed the debt with a loan from Eldridge Corporate Financing in December.

There's definitely leverage on Ark at the corporate level.

www.institutionalinvestor.com/...

[Qichar]

@Tntowldct That is not what I mean. What I mean is, Cathie is not going to get a margin call. If it is a chess game, the hedge funds that attacked Cathie cannot get her to make forced moves. She is free to pick the composition and stocks that she wants, and execute her strategy without interference as she has been doing. That and of course ARKK is an ETF.

Compare this to Archegos, which blew up horribly without really anything unusual happening in the market at all aside from a very predictable rotation out of "growth and tech". Their greed and incompetence resulted in basically a total loss for everyone involved. ARKK on the other hand dropped from 160 to 109, formed a double bottom, and is already back at 127. I'm sure some hedges made some money shorting, but if they were hoping for more they will be disappointed. I bet many already flipped and went long, accounting for the surge in the last few days. See, that's the thing about this kind of tin foil hat theory crafting: it is not like her opponents have any loyalty towards one another. They aren't (publicly) coordinated because that would be collusion which is a big no-no with the SEC. As soon as they think they can make some bank going the other way, they will. And they are.

We're seeing that already in a "rotation" back from value into tech. It's laughable. As if anyone but the most naïve investors ever thought that this wasn't going to happen. People are really confused--they think that the stock market must ALWAYS behave historically. Meanwhile, we are in the midst of one of the most profound technological revolutions in history. Think for just a moment: two short decades ago, the internet was in its infancy. Of course long term, tech is going to get much, much bigger in terms of market cap. It is inevitable. Bears who like to short things like Tesla got a rude comeuppance today to the tune of +8.6%. I wrote that only a few days ago: her picks are a constant upside risk, news could be released on any given day that sends the stock soaring. Today it was Tesla's energy business, which anyone could have anticipated if they even paid a tiny little bit of attention to what Tesla is actually DOING.

[Tntowldct]

@Qichar I agree with you that any of the bets inside one of her ETFs won't get hit with a margin call.

Personally, I'm very concerned about the systemic risk in the innovation sector as a whole. ARK has tied themselves very tightly to the digital finance space which has essentially zero regulation and no requirement to hold reserves. Bitcoin can be bought using 100:1 and 125:1 margin, depending on the brokerage firm you go to and it would not shock me one bit to see a major bitcoin exchange go bankrupt. Additionally, Tesla's 10-K simply says that they invested $1.5 billion into bitcoin. There's nothing in the 10-K that says that they did or did not use leverage. If they used leverage, the pain could be even worse and if people bought cars using bitcoin, they could be building cars for free.

As an aside, the same people that are invested in cryptos are the ones who are tied to the rest of the ARK portfolio. If something goes haywire in the fintech space, ARK will be very exposed to it. That combined with their large positions in illiquid assets could be the match that ignites a gigantic fire.

None of this has anything to do with the fundamentals of Tesla's car business btw.

[Tntowldct]

The whole Ark portfolio is going to get hammered by the inflation storm that's brewing. In the last 90 days, the government tracked inflation rate is annualizing at about 5% per year. The numbers are even worse when you look at raw materials like lumber, base metals, and pretty much every industrial input. Market participants are asleep at the wheel and have no clue what's coming.

Inflation is guaranteed to hit the Ark portfolio in the form of higher implied interest rates.

[Actionable Conclusion]

Well today its Cathie that's doing the hammering. As she has been doing for years.

But maybe the haters who's portfolios pale in comparison, maybe they can cherry pick a few months where Cathie didn't slay the market.

In the long run, fly with the Eagles and avoid the turkeys: ARKK, AAPL, AMZN, TSLA, MSFT, PM, AVB.

[UnderdogAchiever]

@Tntowldct Small caps tend to outperform during periods of inflation, so should be good for her funds. www.perrittcap.com/...

[Tntowldct]

@UnderdogAchiever To an extent that's true. Eventually, price inflation destroys margins which kills earnings.

[Tall Seller]

Pretty wild to map out the compound interest calculations with $ARKK. You can use this compound interest calculator to confirm my calculations below and see with the parabolic growth is like by such compound interest over time:

👉🏻 www.investor.gov/...

Here is a PDF that shows all the annualized (PER YEAR) performance for all of ARK’s ETF’s:
👉🏻 etfs.ark-funds.com/...

Take note from this PDF that $ARKK provided investors 54.34% PER YEAR on average over 5 years. When you plug that interest rate (54.34%), that duration (5 years), and use $100,000 for an Initial Investment amount, the compound interest calculator shows that the initial $100,000 investment turned into a whopping:
🔥 $875,774.87

Just for fun, if you use that same interest rate for a 10 year duration, the $100,000 turns into:
🔥🔥 $7,669,816.24

As Cathie ACTIVELY ROTATES into companies in disruptive niches, who are themselves disruptors too, there is NO REASON (in my opinion) that she can’t continue pick companies that grow substantially over time. I speculate that $ARKK will significantly outperform the markets over time.

LONG $ARKK

[Actionable Conclusion]

"ARK Innovation: How To Invest In Cathie Wood's Hyped ETF"

Depends on the following:

Current exposure to tech.
Risk tolerance.
Time horizon.
Cash percentage.

Either way know this, its a great ETF, the only question is at what price and what bet size.

Me, I sold all at $129 early 2021. Will likely buy back in sub $100. TBC...

[budcorona]

XITK is the closest thing to ARKK in the index world. You can also go with VGT if you like the Raymond James approach. I'll stick with the original. Long ARKK.

[jasonjones]

Lots of speculation dollars here on a can't lose investment. The money to be made has already been made. Get me a time machine!

[Tall Seller]

Pretty cool that ARK Invest’s Director of Research, Brett Winton thinks the 5 core platform segments that ARK focusses on (AI, energy storage, gene sequencing & editing, robotics, cryptocurrency & blockchain) will grow from $14TRILLION in attributable market cap to $28TRILLION over the next 5 years. Check out his Bloomberg interview here:

We Don't Lack Opportunities to Deploy Our Capital: ARK's Brett Winton
www.bloomberg.com/...

Sounds like the right place to park some of my money with ARK Invest for the next 5 years.
👍🏻

[ubkwts]

initially I was using ARKK and ARKW together with VGT to overweight my portfolio to growth. When ARKK and W pulled back near my buy point which I entered on 1/7/2021 I sold before going into the red. I realized I had bought too high. I redeployed those assets into SQ after it's significant drop and I am up 33.00 per share on that position since buying in Feb. I love her thinking and strategy but realized that my risk tolerance, while higher than many who are in their 60's was such that VGT combined with select other growth co's, is a better strategy to let me sleep at night. The strategy you put forth is somewhat of a barbell, with deep value at one end and extreme growth at the other. I prefer to be more in the middle of that with my portfolio still highly weighted with growth. My 5 yr average annual return to date is just over 22%. BTW, if I was in my 20's, 30's or 40's, I would be comfortable buying ARKK and W to hold for many years but as I am approaching retirement I don't have that time frame to wait and I don't need the added alpha so badly to take on the additional risk. I lived thru the 90's tech wreck and paid heavy tuition but the lessons were not lost on me.

[Stomp!]

How to invest or in this case "gamble" on ARK funds ?
EASY buy put options !

[Buyandhold 2012]

How to invest in Cathie Wood's hyped ETF?

Don't.

[Varooom]

@Buyandhold 2012 Could you please explain why not? And is that in the near-term or do not invest in them, period.?

[ZarkaX]

@Buyandhold 2012 do you ever post a positive comments?

[Gaelterra]

ARK Funds are the Hawaiian shirt in my otherwise bland investment closet of blue, button-down apparel.

I use ARK Funds to judiciously provide the longer-term strategic growth in areas of which I have little investment-grade insight in an otherwise staid 70/20/10 DivGro portfolio.

ARK is the Salsa to my bland pile of nacho chips...

[UnderdogAchiever]

@Gaelterra Exactly.

[DM Martins Research]

@Gaelterra "ARK Funds are the Hawaiian shirt in my otherwise bland investment closet of blue, button-down apparel."

I double-like this quote!

[gc03]

@Gaelterra - Dave Ramsey recommends four 'buckets' of mutual funds, and calls the aggressive growth bucket the 'wild child'. ARKK could certainly be classified as a wild child.

[corley10]

I’m a big ARKK believer but it’s only 9% of my portfolio now.

[UnderdogAchiever]

That is roughly my approach. More like 15% in ark, lots of utilities and new energy. Lots of preferred. Cathy is the alpha in our relationship, and most of the beta too.

[Gee Mac]

What are your thoughts on getting in now? ARK is already down a fair bit from its earlier highs...

[DM Martins Research]

@Gee Mac I see no problem getting in for a long term hold -- provided it is just a piece of the puzzle, not the core holding.

[User 21925891]

I like this approach. I am mostly a dividend growth investor, but have recently added some ARK funds to add some pure growth element to the portfolio. I expect these to be long term investments. I am certainly not at the level of 25%, but anticipate gradually increasing the allocation if these funds come under further pressure.

[Tall Seller]

ARK Invest is the most successful Active ETF in the world. There results are mind boggling, really (seen here: etfs.ark-funds.com/... ).

If anyone invested $100,000 in $ARKK 5 years ago, the compound interest for around 54% per year that it returned, would equate to around $874,000!

That’s $100,000 tuned into $874,000.

WOW, right?

By the way, as of January 31, 2021....
• $ARKK has provided investors approx 54% PER YEAR returns over the last 5 years
• $ARKW has provided investors approx 57% PER YEAR returns over the last 5 years
• $ARKF has provided investors approx 107% per year returns over the last 1 years

I am taking my chances with ARK, with their hyper focus on ACTIVELY rotating into disruptive companies in disruptive niches with the potential of massive long term growth ahead.

LONG ARK for me.
📈📈📈🚀🤞🏻🔜💰💰💰

[Chris Lau]

@Tall Seller the number one service here did better than ARKF. But what do those who bought in Feb. Do? They're down.

You never, EVER chase a fund AFTER. By the time the herd joined, it's too late.

Pass.

[Tall Seller]

For me, who cares about short term whoopdidoo volatility. The kinds of companies that Cathie ROTATES into while she ACTIVELY manages ARK’s ETF’s, could very likely equate to the likes of $ARKK becoming a 10 BAGGER in 5-10 years.

LONG $ARKK for me.
📈📈📈📈

[gc03]

@Tall Seller - There are numerous penny pinchers and panic sellers that post here. Long ARKK.