An ARK Invest ETF on steroids?

12/06/2021 | 05:48am

Cathie Wood never stops surprising us. It may even have become her trademark. The famous CEO of the ARK Invest investment fund recently announced that a new ETF will soon be available, which strategy is very interesting. Although it is currently only available to ARK employees, let's take a look at the philosophy behind this new tracker, through the interview Cathie Wood gave to CNBC.

Having put in some (very) disappointing performances since the beginning of the year, it would seem that Queen Cathie has become a little less brilliant than in 2020. The pile of criticism she faces continues unabated, and her recent announcement is unlikely to calm her detractors. The reason is that the new ETF that ARK Invest's teams are working on is said to be based on an "even more" aggressive strategy. Cathie Wood even defined it as ARK "on steroids". This is not a very reassuring description coming from a fund already known for its high risk taking. Volatility should also be much higher than usual. In a way, this is the price to be paid for the expected "overwhelmingly positive performance over the next five years" in C. Wood's own words. If this brief description doesn't surprise you more than that, you should probably not follow the ARK Invest universe assiduously.

Made in ARK Invest

Although the US fund's trackers have raised billions of dollars during the pandemic, ARK Invest is far from a household name among investors. ARK products are often - if not always - based on strategies that can be described as extreme. The movements can be very large, both upwards and downwards. However, the Cathie ideology is simple and consists in targeting and betting on companies that can "disrupt" sectors in the near future thanks to their technological advances. To better understand ARK's philosophy, let's take the first position of its flagship tracker, ARK Innovation. With a weighting of over 10%, Tesla is Cathie Wood's biggest bet. In her eyes, the American company will become the next world leader in the automotive industry. These strong convictions have allowed the ARK Innovation ETF to grow by about 108% since January 1, 2020. Even though market conditions were rather favorable, the performance is nonetheless admirable. But ARK is not infallible and sometimes has to endure significant underperformance. The companies selected are often valued for perfection, and the slightest slip-up leads to very heavy losses. A small position can therefore have a serious impact on the performance of ARK ETFs. Even with a small weighting, companies like Upstart or Zillow collapsing by 50% after posting weak results can ruin the performance of the ETF.

On stock market, being right before others is not always a good thing. It is possible that a scenario is the right one but that the market takes several years to realize it and thus correctly value an asset. Patience and confidence then become the only elements to rely on. Far from the media hubbub, analysts' opinions and short-term news. But one thing is certain, Cathie Wood is one of those investors who rarely doubts. She is convinced that technological innovation will kill companies that do not invest time and money in it. This very strong conviction has even led her to strengthen many stocks since the beginning of the year. Thus, even if the ARK Innovation ETF is down nearly 20% in 2021 against a Nasdaq up 24%, C.Wood continues to strengthen on the downside.

If ARK Invest had to be summed up in a single line, it would be a fund betting on extremely innovative companies, based on sometimes questionable valuation models, but with extremely strong convictions.

Sprinkled with steroids

Nothing is left to chance with Ms Wood: "When risk increases, portfolio managers and analysts typically move back into value stocks, back toward their benchmarks and out of our (growth) stocks, which are a small part of the benchmarks or not part of the benchmarks [.. it's a great opportunity for us, as we've experienced in the last few days, to pick up those stocks because it's just a risk management move to get closer to the benchmarks."

Cathie Wood explains here that in a period of rising risk like the current one, most investors and institutions are moving into larger companies. These are seen as more stable and solid than market disruptors - the ultra-innovative companies that ARK is so keen on. Clearly, Cathie Wood is justifying ARK Invest's poor performance since the beginning of the year in a barely concealed way.

She then adds that the major stock market indexes, filled with these "safe havens", are only going up and ultimately becoming the biggest value traps. In other words, the aging behemoths, looking to the past, will eventually be overtaken by younger, more dynamic and more innovative companies. For the time being, however, these companies are attracting - unfairly, according to Cathie Wood - the majority of capital flows. Two strategies follow from this Ark analysis. Firstly, it seems logical to continue to strengthen growth stocks that are unfairly neglected at the moment. Secondly, ARK will target and then short these large, non-innovative and unfairly overvalued "value trap" stocks. This second strategy is nothing more or less than ARK "on steroids".

"We believe that the benchmarks are where the big long-term risks lie, because they are full of value traps [...] those companies that have done very well historically but are going to be disintermediated and disrupted by the massive amount of innovation that is taking place" says Cathie Wood. Instead of simply betting on the companies of tomorrow, ARK now wants to bet against the companies of today. This idea is actually far from new. She has long waved the flag of "value traps" across major stock indexes, arguing that many companies meet the short-term needs of shareholders by leveraging their balance sheets to pay dividends and buy back shares. As a result, these companies do not have and do not invest enough in innovation and their future. It is this misallocation of capital that will lead to their downfall. "In five years, the world will look nothing like it does today, and we'll be investing in all the disruptors, the winners, who will disrupt the traditional world order".

Cathie Wood believes that a 5-year horizon market inefficiency is currently taking place. But while we often associate market inefficiency with unfairly discounted stocks or overvalued start-ups, she focuses more on aging, overvalued companies, which in her view are attracting too much investment at the moment. The companies targeted by ARK are often under-represented or absent from the major stock market indices, and do not benefit from a massive influx of individual or institutional capital. To support this theory of a "great replacement" within stock market indexes, Wood relies on a few figures. According to research conducted by ARK Invest, innovation is currently valued at between $10 trillion and $15 trillion on financial markets. But within 10 years, disruptive innovation is expected to account for about $200 trillion in market capitalization. This will take "disruptive innovation" companies from just over 10% of global market capitalization to over 50%.

Although these figures come from ARK Invest research, and are therefore probably not free of any conflict of interest, they do open the debate.

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