Since the turn of the year, Catherine Wood (Trades, Portfolio)'s ARK Innovation ETF (ARKK, Financial) has lost more than half of its market value. Many investors seem bemused that the ETF hasn't bounced back from its lows. However, there's substance behind a claim that ARKK may continue to struggle in the short-term due to an unfavorable environment for its strategy. Moreover, I believe it isn't likely to beat the market in the long-run; here's why.
Where Ark Invest is going wrong
First off, Ark Invest's disrputive growth strategy isn't supported by credible financial market-based literature. ETF methodologies usually undergo strenuous statistical backtesting before being delivered to market. However, the ARK Innovation ETF and other Ark funds have neglected the most important financial literature by betting on a "new industrial revolution" of sorts.
Although Wood's speculation on industrialization may be correct, I believe that the idea remains a folk tale when applied to the financial markets.
Modern-day ETF construction is, in most instances, based on factor cycles such as value, growth, momentum and quality. Eugene Fama and Kenneth French first introduced factor portfolios in 1993 as an addition to statistical price discovery literature. Since then, many researchers have embarked on factor pricing models. However, all have concluded that the markets are multifactorial and that a single factor provides poor forecasting abilities.
The chart below illustrates the past 12-months' performance of the following factors:
- Quality (QUAL)
- Value (VLUE)
- Momentum (MTUM)
- Growth (EFG)
- Small-Cap (IJR)
Source: KoyFin
The current market environment seemingly demands high-quality, high-value and low-volatility stocks, which is usually the case whenever contractionary economic spheres develop. The issue for Ark is that it bets on growth alone, which is just one of the many phases of the market, which leaves it with a nearly perfectly correlated portfolio that isn't well equipped to manufacture long-term success. Sure, there are single-factor ETFs out there. However, few of them exhibit the volatility of Ark's funds.
Lastly, ARK Innovation is an actively managed ETF with an expense ratio of 0.75%, which exceeds its asset class average of 0.29%. The excess expense doesn't make much sense for a fund with an information ratio (aka skill ratio) of -1.90, prompting me to conclude that ARK Innovation is overpriced and unlikely to match investors' expectations in the long term.
The bottom line
The ETFs of Catherine Wood (Trades, Portfolio)'s Ark Invest aren't well constructed relative to ETF theory. The ETFs are actively managed, yet their constituents hold a positive correlation. Furthermore, the funds don't exhibit a good skill ratio, and they only take one part of the market cycle into account.
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