ARKK ETF Appears To Be Getting Close To A Bottom

Proving The Doubters Wrong

The Ark Innovation ETF (ARKK) is one of the most hotly debated funds in today’s market. After years of calls for the death of active management, Ark Invest emerged out of near obscurity to disprove this long drawn out belief. With its revolutionary transparency and wide following on social media, Ark Invest has carved out an impressive niche in the cutthroat ETF industry.

Ark’s early success has led to the creation of dozens of copycat funds attempting to take advantage of the public’s newly increased appetite for actively managed ETFs. Cheap beta continues to be commoditized in a race to the bottom on fees, but appetite for Ark’s ETF “hot sauce” has remained impressively strong, especially in the face of its recent severe underperformance.

ARKK’s concentrated portfolio can produce a wide set of outcomes from year to year. Its exclusive focus on high growth disruptive innovation companies has caused it to suffer in the current risk-off market environment. Latecomers to the fund have especially been hurt, with a majority of the total invested dollars in the ETF currently underwater. Money coming in late to the fund is by no means a fault of Ark Invest, but it does raise important questions as to how long its impressive outperformance may last.

A Comparison To The Dot Com Bubble

In my first article on the Ark Innovation ETF I recommended that investors sell their position, as the fund’s high valuation appeared likely to yield poor future returns. I compared ARKK’s dramatic rise to the early days of the Nasdaq-100 ETF (QQQ). I shared this chart showing forward looking returns for investors who bought in near the top of the dot-com bubble.

* Annualized rolling and average returns over full calendar month periods.

Source: lazyportfolioetf.com

It took investors nearly 15 years to break even if they made an initial purchase of shares during the peak of the dot com bubble. A similar outcome may be in store for ARKK’s investors, as the fund has dropped over 40% during the last 12 months. To make matters worse, this has occurred during a positive overall period for the market.

Even after this pullback, the ARKK ETF continues to show strong returns over its most recent 5 year time frame. It is unrealistic to expect outperformance on a year to year basis in any investing strategy, but ARKK’s wild swings tend to be especially noteworthy.

Misjudging A Changing Market Environment

A rise in 10 year Treasury yields over the past year has coincided with ARKK’s portfolio of companies trending in the opposite direction. A further rise in this benchmark yield will likely result in its continued underperformance. Ark Invest’s maintained belief that inflation would prove transitory has been harmful to its performance in recent months. A large portion of ARKK’s portfolio is invested in non-profitable technology companies that are vulnerable to larger than average pullbacks in a rising interest rate environment.

10 Year Treasury yields fell precipitously from their highs above 3% in late 2018. Owing to the Federal Reserve’s emergency pandemic response, these yields had remained depressed throughout early 2021. ARKK’s portfolio of companies were ideally positioned to take advantage of this macro setup.

With excess liquidity being pumped into the markets and historically low interest rates, ARKK’s portfolio of companies benefited from a greater than average P/S expansion.

Prior to the pandemic in February 2020, the median P/S ratio for companies in ARKK’s portfolio was 8. By June 2021, the median P/S ratio had more than doubled to a peak above 19. Coinciding with its recent pullback, the median P/S ratio for ARKK’s portfolio of companies has fallen back down to 14. This cheaper valuation should bode well for ARKK’s future returns. The ETF still does not appear cheap however, when compared to a long term median P/S ratio below 10.

Doubling Down on COVID Winners

The sustained rise in 10 year Treasury yields does not fully explain the reason for ARKK’s dramatic underperformance over the last year. Ark Invest continued to add to the positions of some of its biggest COVID winners, despite many of them suffering fading tailwinds. The pandemic pulled forward many years of revenue for companies in ARKK’s portfolio, most notably Zoom (ZM), Teladoc (TDOC) and Roku (ROKU). It was unrealistic to expect these businesses to maintain a similar level of revenue growth going forward. Ark’s reckless buying of the dips is another major reason why it continued to underperform so dramatically.

Conclusion

Ark’s portfolio was perfectly setup to take advantage of many of the pandemic’s tailwinds, but is likely to remain vulnerable to further correction in a continued rising interest rate environment. With that being said however, ARKK is starting to look attractive for investors with a higher than average risk tolerance, and long term investment horizon.

ARKK’s portfolio of companies has gotten cheaper during this recent selloff, and now may be a good time to start dollar cost averaging into the fund. With higher growth rates expected from ARKK’s portfolio of companies, its elevated valuation may potentially be justified.

Enhanced volatility lends better results with a dollar cost averaging strategy. Investors looking to gain exposure to growth companies outside of the SP 500 may wish to consider purchasing ARKK on any future weakness.