The decade-long period of so-called "zero interest rate policy" (ZIRP) has had some interesting effects on capital markets and investor behavior. ZIRP’s most obvious impact, as I have discussed previously, has been the marked bending of the yield curve. The resultant yield compression, which can be seen across all classes of corporate and sovereign debt, has been a veritable godsend for zippy high-growth companies, which have been able to take on historic amounts of debt at historically low cost.
But alas, the ZIRP party appears at last to be coming to an end. The Federal Reserve and other major central banks have signalled their intention to begin hiking rates over the course of the next year. With rising interest rates on the horizon, the market has shown signs of rising skepticism toward once high-flying growth stocks, especially those with little prospect of turning a profit anytime soon. That is fast becoming a problem for the ARK Innovation ETF (ARKK, Financial), the $21 billion flagship exchange-traded fund of Catherine Wood (Trades, Portfolio)'s Ark Investment Management.
Rate hike blues
Over the course of the long ZIRP era, profitability seemed to become less and less important to investors even as forward-looking valuation multiples expanded to record levels. The market rewarded many deeply unprofitable growth stocks with enormous market capitalizations based on expectations of bright, but often distant, futures. Capital flooded in from investors and allocators who were on the hunt for higher returns in the ultra-low rate environment.
This proved to be the perfect environment for ARK Innovation, thanks to its being composed almost exclusively of unprofitable technology and innovation-focused companies. However, with rate hikes coming into sight, many of the ETF's positions have taken on water, as AJ Bell’s Russ Mould pointed out on Dec. 6:
“There has been an ebbing of enthusiasm for high-growth tech stocks. A lot of Ark Innovations’ holdings don’t make money and in an environment where interest rates are expected to rise, this is not necessarily the place you want to be. [There are also] some stock-specific challenges, which have exposed some very lofty valuations.”
Seeing red
The carnage has not been isolated to a few names. Indeed, nearly every single stock in the ARK Innovation portfolio has been battered recently. As of Dec. 4, all but four stocks owned by ARK Innovation were in full-blown bear market territory.
Many of the ETF’s biggest holdings are now deeply in the red, such as Teladoc Health Inc. (TDOC, Financial), which has fallen 53% over the course of 2021. Zillow Group Inc. (Z, Financial) is another major ARK Innovation holding that has, for a number of reasons, seen its star fade of late. Zillow is currently down 55% year to date.
No path back to black
When market fears are on the rise, volatile fund strategies tend to be viewed with greater skepticism. ARK Innovation is especially vulnerable to such conditions, due to its inherent susceptibility to volatility swing, as Morningstar analyst Robby Greengold pointed out on Nov. 30:
“The fund’s relative results tend to be boom or bust. Its relatively concentrated and benchmark-agnostic portfolio means investors should have a stomach for volatility.”
The speed and scale of the recent growth of ARK Innovation’s assets under management have only made the situation worse. As I warned back in February, massive inflows could end up creating profound liquidity problems for ARK Innovation down the line due to the ETF’s core strategy, which is based on maintaining a highly concentrated portfolio of a relatively small number of growth names. Judging by its performance in 2021, my initial misgivings about ARK Innovation appear to have been justified.
My take
Down 21.5% so far this year, the ARK Innovation ETF looks awfully battered and bruised at the moment. However, I fear the worst may be yet to come for Ark Invest’s flagship ETF, especially if rate hikes proceed as anticipated. In a rising interest rate environment, ARK Innovation’s particular brand of investing is likely to struggle, in my assessment. If volatility continues to intensify as well, things could get even worse.
Ultimately, I can find little in the way of inducement to invest in this particular ETF.
