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ARK Innovation: The Harsh Reality About Cathie Wood’s Flagship ETF

ARK Innovation has been performing poorly in 2021. But even worse and unbeknownst to many, Cathie Wood’s flagship fund has failed to impress relative to its key benchmark since inception.

Cathie Wood’s ARK Innovation ETF  (ARKK) - Get ARK Innovation ETF Report has been a loser in 2021. So far this year, the popular tech-heavy fund has produced losses of -25% against the S&P 500’s +22% gains. Since peaking in February, ARKK has declined a whopping 40% in less than one year.

Many could understandably make a case for buying ARK Innovation on this massive dip, or stocks contained within the ETF — Tesla  (TSLA) - Get Tesla Inc Report, Roku  (ROKU) - Get Roku, Inc. Class A Report and Teladoc  (TDOC) - Get Teladoc Health, Inc. Report are the top three holdings. But I suggest potential investors keep one important thing in mind.

Figure 1: ARK Investment Management on NYSE.

Figure 1: ARK Investment Management on NYSE.

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Aggressive growth, but at what cost?

Most investors know that higher expected returns usually come hand in hand with higher risks. However, when assessing the investment opportunity in a fund like ARKK, many underestimate or simply ignore considerations like potential drawdowns and historical volatility.

In measuring risk-adjusted performance, Sharpe ratio is a common metric to consider. In its simplest form, this is the ratio of annual returns divided by annualized volatility in daily performance. The higher the Sharpe, the better the historical risk-adjusted returns.

The graph below shows ARKK’s running Sharpe ratio since inception, in blue. The line is compared to the same metric for the Nasdaq  (QQQ) - Get Invesco QQQ Trust Report and the 2x leveraged Nasdaq ETF, ProShares Ultra QQQ  (QLD) - Get ProShares Ultra QQQ Report.

Figure 2: 5-year running Sharpe ratio: ARKK vs. benchmarks.

Figure 2: 5-year running Sharpe ratio: ARKK vs. benchmarks.

Cathie Wood’s overarching strategy is to invest in disruptive technology and in companies that have been spearheading the revolution. So, one might think that such a novel and visionary approach should produce market-beating performance over time.

The truth is that ARKK has not consistently offered superior risk-adjusted returns compared to the Nasdaq. This observation is represented by the blue line above not staying above the gray lines for much longer than a few months at a time.

To be fair, ARKK has moved higher than the Nasdaq since the ETF’s inception, nearly a decade ago: 26% average returns per year vs. the benchmark’s 22%. But again, the higher returns have come alongside much higher risk and volatility.

Some growth investors may be asking themselves: “what do I care about risk and volatility? I just want my portfolio to grow over the next few decades, so only absolute returns matter”. To that, I would argue that ARKK has still been a subpar alternative.

Here is one example: a portfolio that is allocated 90% to a leveraged Nasdaq fund like QLD and 10% to cash, rebalanced quarterly, would have produced virtually the same volatility and drawdowns as ARKK since 2014. However, this portfolio would have earned 10 percentage points per year of additional returns!

That is, for very comparable risk, a $100,000 initial investment would have been around $375,000 larger now if invested in a leveraged Nasdaq-plus-cash strategy than if invested in ARK Innovation since inception.

Key takeaway

I must admit that I appreciate Cathie Wood and her team’s bold convictions. Rather than being scared of inflation and rising rates, which has led many investors to turn to conservative, “hard” asset classes like commodities and real estate lately, ARK Invest continues to double down on the “technologies of the future” theme.

That said, history has not been on the side of ARK Innovation, Ms. Wood’s flagship fund. Bulls could reasonably argue that now is a good time to buy the ETF, following massive underperformance in 2021. I, on the other hand, wonder if doing so would only lead to inferior risk-adjusted returns going forward, as has been the case for the past many years.

(Disclaimers: this is not investment advice. The author may be long one or more stocks mentioned in this report. Also, the article may contain affiliate links. These partnerships do not influence editorial content. Thanks for supporting Wall Street Memes)