- 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.
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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.
- 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.
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:
- The high reward, high risk profile that makes the fund a good complement to more conservative holdings, and
- 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.
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This article was written by
Daniel Martins is a Napa, California-based analyst and founder of independent research firm DM Martins Research. The firm's work is centered around building more efficient, easily replicable portfolios that are properly risk-balanced for growth with less downside risk.
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Daniel is the founder and portfolio manager at DM Martins Capital Management LLC. He is a former equity research professional at FBR Capital Markets and Telsey Advisory in New York City and finance analyst at macro hedge fund Bridgewater Associates, where he developed most of his investment management skills earlier in his career. Daniel is also an equity research instructor for Wall Street Prep.
He holds an MBA in Financial Instruments and Markets from New York University's Stern School of Business.
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On Seeking Alpha, DM Martins Research partners with EPB Macro Research, and has collaborated with Risk Research, Inc.
DM Martins Research also manages a small team of writers and editors who publish content on several TheStreet.com channels, including Apple Maven (thestreet.com/apple) and Wall Street Memes (thestreet.com/memestocks).
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.
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