ARKK's Claims of an Anti-Innovation Market Ring Hollow

Since its meteoric rise in 2020, ARK Innovation ETF ARKK has been one of the worst options among more than 5,000 U.S. open-end and exchange-traded equity funds. Its 44.3% loss over the trailing year through Jan. 14, 2022, wasn't just poor compared with the Russell Midcap Growth Index's modest decline, it was wretched versus the tech-heavy Nasdaq Composite and Invesco QQQ Trust's QQQ respective 14.3% and 21.6% gains.

Exhibit 1: Only a Handful of U.S.-Sold Funds Performed Worse Than ARK Innovation Over the Past Year

Source: Morningstar Direct.

ARK's portfolio manager Cathie Wood has taken to the airwaves and penned a blog to say the strategy's merely out of favor. Investors have punished "innovation stocks" amid steep rises in consumer prices and other signs that the Federal Reserve's ultra-loose monetary policy will quickly tighten. They've fled to their benchmarks' holdings, she says. ARK Innovation has embraced the abandoned nonindex holdings to build a distinctive portfolio--a source of pride for Wood.

It's hard to find data that support these points.

ARK Innovation's Relatively Few Unique Holdings Have Been Resilient

Only around one fourth of ARK Innovation's holdings aren't in the Russell 3000 Index--a popular and sweeping equity-market tracker--and these out-of-index positions have not driven the strategy's underperformance. They amount to a minority of the strategy's assets and have mostly held up better than the broader portfolio. Rather, 50-plus of the 70 or so stocks owned at some point over the past year have done most of the damage, with each falling 20% or more while held.

Exhibit 2: Performance of the Stocks That ARK Innovation Held at Some Point During the Trailing Year

Source: Morningstar Direct. Data as of Jan. 14, 2022.

Signs of an Anti-Innovation Bias Are Hard to Find in the Market

Did a marketwide fire sale of innovation stocks burn ARK Innovation? Not quite, judging from the MSCI ACWI IMI Innovation Index. Recently developed in collaboration with ARK Invest, this index gained 7% in 2021 thanks to constituents such as graphics chipmaker Nvidia NVDA, which more than doubled in value. Wood had held Nvidia but sold it in April 2020. Wood's investments in the FAAMG stocks--Facebook (now Meta Platforms) FB, Apple AAPL, Amazon.com AMZN, Microsoft MSFT, and Google (now Alphabet) GOOG--tell a similar story. Wood had owned each in recent years, but not over the past year when all but one gained at least 35%.

The Strategy's Aggressive Posture Has Hit Headwinds, Not the Typhoon That ARK Claims

Cathie Wood also believes that algorithm-driven strategies have reacted to the market's macroeconomic concerns by "simplistically" selling stocks trading at high prices relative their earnings, sales, or book value. That theory is difficult to confirm or disprove. But it also seems a minor point to her important observation that rising interest rates typically disadvantage the stock-price performance such companies, whose profitability often isn't expected for years. The kind of aggressive-growth stocks Wood favors are an example.

Indeed, across all funds in the large- and mid-cap growth Morningstar Categories (two segments that ARK Innovation emphasizes), the poorest performers tended to be those with the most exposure to stocks with high price multiples, low dividend yields, and rapid long-term earnings-growth prospects, as reflected in their portfolios' high value-growth scores. So, given ARK Innovation's aggressive-growth posture, it is reasonable for it to have underperformed its peers over the past year.

Exhibit 3: Portfolios With the Highest Value-Growth Scores Have Posted Negative Returns, on Average

Source: Morningstar Direct and author's calculations.

But investment style doesn't explain the magnitude of ARK Innovation's losses. Growth funds with value-growth scores in the broader cohort's top decile--those deserving of the aggressive growth label--fell by around 8%, on average--a far cry from ARKK's 44% loss.

Exhibit 4:

Average Total Returns Over the Past Year for Funds With Similar Value-Growth Scores

Source: Morningstar Direct and author's calculations.

Cathie Wood's Assurances

Describing herself as more comfortable today than in mid-February 2021, when shares in ARK Innovation were double their current value, Wood derides the public equity market's understanding of innovation and exponential growth. The fund is now at a bargain price, she suggests by depicting ARK's holdings as deep-value stocks. She advertises big rewards for fund investors who stick with her: Over the next five years, she expects ARK Innovation to deliver a nearly 40% annualized total return.

Among her most consistent messages in recent months has been that the prices of innovation stocks have not been irrationally high as technology and telecom stocks became in the late 1990s.

By historical standards, Wood's return forecast is possible but improbable. Less than 2% of U.S. funds (alive or dead) have achieved such a feat over any rolling five-year period since 1980. Many did so during the late-1990s bubble.