ARK Innovation: Music Stopped, But Still Buying The Dip

Thesis

Cathie Wood’s flagship ETF ARK Innovation (NYSEARCA:ARKK) fund has lost more than 55% YTD and hopelessly underperformed the broad market (SPX reference), which is ‘only’ down by about 20%. And as a consequence, since December 2021, ARK Investment Management has lost almost half of the firms’ assets under management. Time to rethink the investment strategy? No, not likely. In an interview with the Financial Times, Cathie Wood said:

Ark also has to do with battle … Battling the traditional world order.

And this is exactly what an analyst can observe. Cathie Wood is fighting. She is fighting the inevitable change towards higher interest rates and the fading attraction of richly valued tech/innovation stocks.

When a strategy is clearly not working, a successful investor must be flexible and humble enough to adapt to his strategy to the new situation. If an investor, however, wants to keep faith to her investment style (perhaps because she wants to stay in her circle of confidence), then at least she should wait out the storm. Cathie Wood is doing neither and as a consequence, in my opinion investors are well advised to avoid Cathie Wood’s ARK Innovation ETF.

Buying The Dip

Following a hotter than expected CPI report for August, stocks sold off sharply. This day, the S&P 500 (SPX) lost more than 4.3%. And the growth-sensitive index Nasdaq 100 lost even more, 5.2% respectively. Technology clearly suffered badly, because out of the Nasdaq’s 100 constituents, there was not one single name that appreciated in value.

But Cathie Wood arguably liked the day and — keeping faith with her sometimes (in my opinion) outlandish predictions — disagreed with the consensus. ARK Investment Management bought 27 stocks, celebrating her largest dip-buying since February 2021. Twilio (TWLO) and Roku (ROKU) where her largest purchases, according to data compiled by Bloomberg. Twilio and Roku, for example are both down more than 70% YTD.

ARK Investment Management is selling winners and buying losers. To finance additional purchases, Ark sold parts of its position in Tesla (TSLA), arguably ARKK’s most profitable investment, and in Signify Health (SGFY), which has appreciated by more than 160% since June. Notably, Cathie Wood also decided to sell out on Israel-based Nano Dimension (NNDM), which is now trading at a negative enterprise value of -514 million.

Underperformance Is Structural

Reflecting on Cathie Wood’s investment strategy, I have little confidence that her flagship fund will outperform in the future. The history at least agrees with my thesis.

The ARK Innovation ETF is down 56% year to date and has underperformed the broad market by about 35 percentage points.

Notably, on a 5-year timeline Cathie Wood’s ‘revolutionary’ investment style has now also underperformed Warren Buffett’s Berkshire Hathaway (BRK.B) (BRK.A).

But to avoid the danger of comparing apples (value investing) with oranges (growth/tech investing), let us compare Ark’s flagship fund not to Buffett’s the exceptional active asset-allocation skill, but to passive index investing in technology.

Comparing ARKK with the Nasdaq 100 is even less favorable for Cathie Wood. Since mid-2018, ARKK has returned only 24.5% versus a gain of 98% for the NDX. In other words, the ARK Innovation fund underperformed by a factor of x4.

Still Vulnerable To Higher Rates

Although ARK Innovation ETF is down a lot, the fund is still very vulnerable to higher yields. I have recently highlighted the mechanism how higher interest rates cool down economic activity:

There are multiple powerful channels how higher interest rates will impact economic activity. First, higher interest rates limit credit expansion and thus demand in an economy. Second, higher interest rates pressure the housing market through higher mortgage payments and general funding. Third, higher interest rates increase the cost of debt, which in turn lowers free income available for consumption and/or investment. All this will eventually lead to a slower economy, if not recession.

Note, however, that the above arguments are only examples of first round effects. A slowing economy will eventually provoke an EPS contraction, which leads to lower investor confidence and consequently also to even lower stock prices. This in turn will further pressure the economy. Needless to say, this is the anatomy of an anti-virtuous cycle that is likely to continue until something breaks, and the Fed will need to step in with a liquidity put.

According to a recent article published by the Financial Times, economists predict that the FED funds rate will peak between 4-5% this tightening cycle. Based on a survey of 44 economists, consensus also believes that the Federal Reserve will maintain interest rates above 4% beyond 2023.

Growth stocks are notoriously very sensitive to higher rates. And ARK Innovation is strongly invested in growth. Out of ARKK’s largest investments, Zoom (ZM) is the stock that looks the most like value to me – and arguably this should say everything that needs to be said.

Here are the fund’s 10 largest holdings.

Investor Takeaway

Key Points

Ark’s Innovation ETF will inevitably continue to be under pressure, in my opinion, as the Federal Reserve increases interest rates in an unprecedented aggressive fashion. But Cathie Wood is still ‘in battle’: She is buying the dip; She is arguing against higher rates and inflation (recently tweeted that deflation is ‘in the pipeline’) And she is fighting the idea that an investment is about buying assets at a reasonable valuation — doubling down on richly valued tech/growth stocks.

Going into battle is hard. And it can be costly. Would you like to join the fight?

Final Word

The next months will likely be very challenging for investors. And personally, given the arguments provided in this article, I do not trust that Cathie Wood’s ARK Innovation ETF will manage to navigate these stormy waters. I rate it a sell.