Stock Market

When markets closed last month, it became official:

Cathie Wood’s ARK Innovation ETF (NYSEARCA:ARKK) had scored its best-returning month in its 9-year history.

The 27.8% return in January was a welcome reversal for the struggling fund. The ETF had lost around 80% of its value since 2021. And it made some of Ms. Wood’s most outrageous claims seem a little less outrageous.

I’ll admit I’ve also long been skeptical of ARK Invest and its investment approach. The company’s history of stretching target prices to suit its narrative… doubling down on money-losing firms… and my general wariness of anything that seems remotely popular… has long kept me away from most ARK-type stocks. (I was clearly not a trendsetter in high school).

Yet, even my conservative nature pales to the contempt that Wall Street often heaps onto Ms. Wood and her ETFs.

“Cathie Wood lacks a robust approach to understanding or mitigating the portfolios’ risks and instead relies on her instincts,” Morningstar strategist Robby Greengold remarked in an investor note. “The firm, which has no risk-management personnel and vaguely defined risk controls, views the subject almost exclusively through the lens of its bottom-up stock research.”

Of course, the bottom-up approach does have its merits. Benchmark-agnostic strategies have long helped funds from Warren Buffett’s Berkshire Hathaway (NYSE:BRK-A, NYSE:BRK-B) to Bill Ackman’s Pershing Square outperform markets. Academic studies have shown that specialist funds tend to outperform “shadow indexing” ones that track markets.

But this laser-like focus is a double-edged sword. And seven words from Ms. Wood’s interview with CNBC on Feb. 1 encapsulate the issue:

“Our focus is solely on disruptive innovation.”

A Sole Focus on Disruptive Innovation

Immediately, the old Wall Streeter in me spots an issue with those seven words:

Ms. Wood’s comment shows she’s investing in disruptive companies regardless of ETF industry norms. That includes price, benchmarks and risk.

Consider the alternative. Most actively managed ETFs today are focused on outperforming the market within a set of risk constraints. And the “market” is generally a well-defined benchmark (S&P 500, FTSE SmallCap Index, Dow Jones U.S. Airlines Index, and so on).

That forces a manager to show they’re generating “alpha” rather than spending their day throwing pencils into the ceiling. Otherwise, an unscrupulous fund manager could simply return 2x by leveraging customer funds up 100%. Or say they’re doing well by retroactively changing their benchmark to a lesser-performing one (i.e., the equivalent of changing the test question to suit a wrong answer).

Instead, Ms. Wood’s focus on disruptive innovation means that ARK Invest and its ARKK ETF has no clear benchmark nor any risk mandate. If it rises 27.8% in a month… or drops by the same amount… it still says nothing about the process behind the decision-making.

And given her extreme popularity among retail investors, it’s no surprise that a measure of professional jealousy has seeped in.

Areas Where Focus Works…

For some strategies, this seven-word approach works surprisingly well. ARK Genomics Revolution ETF (BATS:ARKG) — the company’s bet on emerging biotech companies — excels at its mandate. Biotech startups rarely produce revenues, so fundamental valuations matter far less than market analysis. Even the best biotech analysts tend to use wooly concepts like “market size” and “penetration rates” as stand-ins for a biotech’s value. (One may even argue that an endorsement by Ms. Wood’s fund makes it easier for these biotech moonshots to raise more capital and complete clinical trials).

Benchmarking is also particularly tricky because large biotechs differ greatly from smaller ones. Almost a third of the iShares Biotechnology ETF (NASDAQ:IBB) is invested in Gilead Sciences (NASDAQ:GILD), Amgen (NASDAQ:AMGN), Regeneron (NASDAQ:REGN) and Vertex Pharmaceuticals (NASDAQ:VRTX) — four firms that look more like biotech marketing companies than R&D outfits.

Picking biotech winners also requires extensive knowledge of the drugs themselves. If 20 therapies using a particular pathway have failed in clinical trials, then it’s unlikely that the 21st will do any better. It’s no surprise that ARK’s genomics fund has outperformed the broader biotech market by almost 1% since inception after fees, despite a massive crash of zero-revenue biotechs.

…And Where ARK Fails

Yet, Ms. Wood’s laser-like approach to “disruptive technologies” alarms many Wall Street investors.

“66-year-old Wood is essential as the firm’s lone portfolio manager,” Greengold continues about ARK Invest. “Exacerbating that key-person risk is the firm’s inability to develop and retain talent: Many of its analysts have come and gone, and most of the nine remaining lack deep industry experience.”

It’s a flaw that clearly shows in ARK’s stock selection. Nine of the top-1o holdings in its ARK Next Generation Internet ETF (NYSEARCA:ARKW) are also held in its flagship ARKK ETF, suggesting a lack of good ideas. And ARK Venture — the company’s private/public fund — also names Ms. Wood as its sole portfolio manager. One wonders how Wood has time to manage seven widely different portfolios.

The funds have also underperformed on a broader level. Since its inception, ARKK has only returned an annualized 6.8%, compared to 10% in the S&P 500 and around 14.4% for the tech-heavy Nasdaq index. And it’s a fact that traditional money managers have used to pan the ARK funds.

“In the community of professional money managers, no one is more vilified than Cathie Wood,” notes Bloomberg Opinion’s executive editor Robert Burgess. “Her detractors criticize Wood for making big calls … Her ETF’s jaw-dropping gain of about 150% in 2020? That was more due to circumstance than skill, they say.”

Should Investors Buy the ARKK ETF?

By her own admission, the Los Angeles-born fund manager was an accidental celebrity.

“[Our firm] did have a social strategy, but I was hoping to make the young people—analysts, portfolio managers, advisors—famous, not myself,” she told the British weekly newspaper The Observer at an event last year. And the envy is palpable; an ETF that bets against Ms. Wood’s fund (aptly named SARK) has almost $300 million in assets under management.

Yet, Ms. Wood and her seven-word strategy do have significant qualities. Most obviously, it’s an extraordinarily consistent worldview that investors can understand.

“There are a ton of ETFs out there, but this one does have a clear following,” said Chris Murphy, Susquehanna’s co-head of derivative strategy. “She is consistent. She sticks to her guns.”

ARK’s price-agnostic strategy thus makes it a powerful tool for swing traders and hedgers, especially those looking for high-beta assets. According to data from Thomson Reuters, ARKK has a strong 0.85 correlation with the popular Invesco QQQ Trust (NASDAQ:QQQ) while having a beta almost 40% higher. For quant-based traders, it’s a way to gain additional leverage without buying on margin.

In other words, if you’re a hedged investor looking to supercharge your portfolio during good times, then the ARKK ETF was purpose-built for you. The “long-duration” fund is almost guaranteed to rise whenever the Federal Reserve begins cutting rates again, while Ms. Wood’s focus on higher-quality moonshots provides some protection on the way down.

But if you’re an ordinary investor, then ARKK isn’t the best choice. Ms. Wood’s concentrated portfolio means individual investors can mimic much of her fund in relatively few trades. And its 0.75% expense ratio is 50% higher than the typical fund. It’s little surprise that no ARK fund (besides its genomics one) has outperformed the market in any meaningful way since its inception.

Nevertheless, many retail investors will continue buying Ms. Wood’s ETF anyway. Her commitment to “disruptive innovation” grates against the status quo of traditional managed ETFs. And for many, that’s enough reason to jump in.

On the date of publication, Tom Yeung did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the Publishing Guidelines.

Tom Yeung is a market analyst and portfolio manager of the Omnia Portfolio, the highest-tier subscription at InvestorPlace. He is the former editor of Tom Yeung’s Profit & Protection, a free e-letter about investing to profit in good times and protecting gains during the bad.

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