I recently saw a video from YouTuber Meet Kevin discussing what he called “the collapse of
index funds”. I’ll link it below so you can check it out, but this really struck a chord
with me as someone who has been investing pretty heavily in index funds so far.
To summarize the arguments he presented, the idea is that index funds put too much money in the
wrong places, and end up underweighted in today’s most important stock market holdings. Similarly,
he referenced Cathie Wood from Ark Invest who believes that we’re entering a new era, where
money is going to start flowing out of traditional and “old” companies, and into companies that
are disruptive innovators, specifically in the area of science and technology.
I think there is some truth to both of these ideas, especially the idea that disruptive tech
companies will be some of the best stock market investments we can make in the coming years.
So, in order to bring my total market index fund holdings down a little bit,
and shift some weight into these types of companies, I want to analyze two popular ETFs.
In this video, we are going to compare the ARK innovation ETF, ticker ARKK,
and Invesco’s QQQ ETF.
First, we’re going to look at how each fund is managed.
This is going to include a look at the methodology or strategy behind each fund,
to figure out how they’re choosing the underlying investments.
Then, we’ll take a look at the current holdings of each
fund so we can get a read on the amount of diversification we’re getting with each one.
Next, we’re going to take a look at numbers like price, valuation metrics,
costs and more to figure out if either of these funds are a good buy today or in the future.
Finally, I’ll tell you how I’m going to be investing in these funds
and how they fit into my overall portfolio.
So if you’re thinking about investing in one or both of these funds,
stick around for everything you need to know.
Both ARK and the triple Q are designed to focus on companies that are at the forefront of innovation.
But, the way each one does it is a little different.
The primary difference here is that ARKK is an actively managed fund,
while triple Q is a passively managed index fund that invests in the NASDAQ
100. So let’s take a closer look at what’s going on behind the scenes of each of them.
The ARKK ETF is managed by the ARK Invest team, which is famously led by CEO Catherine Wood.
According to their website, their investment strategies “span market capitalizations,
sectors and geographies” to focus on companies that they expect to be “the leaders,
enablers and beneficiaries of disruptive innovation.” So these guys are betting
on companies that they expect to drive and benefit from innovation the most,
specifically mentioning the areas of DNA technology, industrial innovation,
the next generation internet and financial technologies or “fintech”.
Ark Invest believes that we are currently amidst
the largest technological transformation in history,
which means potentially incredible opportunities financially. This chart from their website shows
groundbreaking innovations that have developed over time and ultimately shaped our world.
They point to huge opportunities thanks to five innovative platforms that are evolving rapidly
today: energy storage, artificial intelligence, robotics, genome sequencing and blockchain.
In order to meet their definition of innovation,
they think a company’s technology must meet three criteria.
First, it must deliver extreme cost cuts or performance improvements. Although some
technologies advance slowly, ARK points to something called Wright’s Law to explain the
potential benefits of a breakthrough technology. At a certain point, cost and performance reaches a
threshold where it suddenly becomes widely more available and transformative on a large scale.
So, they seek companies with the potential to deliver on the other side of that threshold.
Second, the technology should be able to transform multiple industries. Identifying
these technologies ahead of time can enable you to benefit from the point where the technology breaks
through into different industries and gets rapidly implemented into different sectors. The example
they give is electricity, which within 30 years penetrated almost every sector of manufacturing.
And last, the technology must also provide a platform for further innovation. They want
to find technologies that can endlessly be built upon, spawning even more products,
technologies and innovations. The example they give here is how new battery technologies have
paved the way for other technologies like drones and electric vehicles.
So now we know the beliefs and ideas that drive their investment decisions and philosophy.
And when it comes to selecting specific stocks for their portfolio, this is what they say:
Instead of starting with a benchmark, they begin with a pool of potential investments that they
evaluate and quantify based on their opportunity for growth. Then they build out a five year model
to estimate the potential value of a company based on a handful of characteristics. After
all of this, CEO Cathie Wood has the final say on which stocks end up in the portfolio.
After adding stocks to their portfolio, they’ll add or trim their positions to take advantage of
short-term negative price movement, to move assets to a holding they’re more confident in or if they
spot an investment with great market opportunity. They also say they’ll sell a holding if it no
longer appears to be leading innovation or if their research no longer supports it. These are
all pretty standard claims, and basically they’re just going to move in and out of stocks when
they feel the time is right and there is a good opportunity. Of course, this is the primary risk
of actively managed funds. They’ll use strategies that attempt to time the market which often
involve short-term trades, resulting in higher costs and the risk of mis-timing an investment.
This is in direct contrast with QQQ, which follows a passively managed strategy by investing
in the NASDAQ 100 index. This index simply includes the 100 largest stocks by market cap
on the NASDAQ index, but excludes any financial companies. So instead of cherry picking stocks,
triple Q just invests into the NASDAQ 100 index based on their market cap weighting
of stocks. And this means to understand triple Q, we need to understand how the Nasdaq index works.
The NASDAQ is the second largest stock exchange in the world, behind only the New York Stock
Exchange. The NASDAQ came about in the 70s and separated itself from the New York stock exchange
because it was the first electronic stock exchange in the world. As a more innovative
exchange platform, it attracted a lot of newer and smaller technology-based companies.
So from the very beginning, the Nasdaq offered a selection of stocks that was
more saturated in the technology industry, and this is a trend that continues to this day.
So when you look at the top 100 listings of the NASDAQ index, which make up the NASDAQ 100,
this is why it looks different from something like the S&P500 which selects stocks from both the
NASDAQ and New york stock exchanges. Ultimately, the NASDAQ 100 and the triple Q ETF aren’t using
any strategy to identify innovative companies - but, because of the historic bias of the NASDAQ
platform, the largest 100 companies on the NASDAQ index just tend to lean more towards technology
and will inevitably include some of the most successfully innovative companies out there.
So when you compare the strategy of ARKK and triple Q, there are some pretty clear differences.
ARKK is going to select from a wider pool of investments, and strategically select the stocks
that they anticipate will have the biggest growth opportunities. This will include exposure to
small and medium cap stocks, while the nasdaq 100 will be composed of the largest possible stocks.
So with ARKK you’re going to get a more targeted approach that aims to capitalize on
growth opportunities, albeit with the risk of active management. However, active management
also gives ARKK the ability to add new holdings at any time, while triple Q will only be able to add
new holdings on an annual basis. Furthermore, QQQ will give you a broader investment into
the largest companies on the NASDAQ index, but by focusing on the 100 largest stocks,
it may be overweight in some of the companies that have already achieved much of their growth.
I think this could suggest less growth potential, but a smoother ride along the way.
So let’s take a closer look at their holdings. ARKK aims to hold between 35 and 55 holdings at
any given time, which is going to be less than the 100 stocks that triple Q holds.
Here you can see ARKK’s top 10 holdings, which make up about 50% of the portfolio.
It’s heaviest in healthcare technology, which makes up 35% of the portfolio
and focuses on things like molecular diagnostics, gene therapy and other DNA technologies.
Close behind is a 28% weight in information technology,
which will include things like cloud computing, big data and the internet of things.
Here you can see their weight by market capitalization,
which shows that half the portfolio is allocated into large cap stocks,
giving some pretty decent exposure to smaller-sized companies.
So I think these holdings provide some clear insight into the core technologies and strategies
that ARKK believes in, and they definitely align with the information we looked at earlier.
On the other hand, as we know, triple Q holds 100 stocks. 100% of this portfolio will be in large
cap stocks. Currently, the top 10 holdings of QQQ make up about 55% of the portfolio,
which makes it a little more top-heavy than ARKK. You can also see that it’s pretty heavily weighted
in its top 3 holdings alone, with 35% of the portfolio made up of Apple, Amazon and Microsoft.
The sector allocation is also pretty different from ARKK. With triple Q,
almost 50% is allocated to information technology, and it holds way less in the healthcare industry
compared to ARKK. Communication services and consumer discretionary is fairly comparable.
Directly comparing the two, although triple Q appears to offer better diversification
with nearly twice as many holdings, it’s pretty heavily weighted into a select
few of them. I think ARKK will provide better diversification across different market sectors,
and like we touched on earlier, it has the added benefit of selecting from a wider
pool of stocks that will include smaller market caps and greater growth potential.
But let’s take a look at the numbers behind each of these ETFs, starting with ARKK.
ARKK charges an expense ratio of .75%,
which is definitely high compared to passively managed funds, but it’s actually pretty
competitive for an actively managed fund. It does not pay a regular dividend, which is
pretty much to be expected for a portfolio that is entirely focused on disruption and rapid growth.
The returns from ARKK have been absolutely incredible,
with 30% annualized returns since its inception in 2014. Of course,
the majority of this has occurred in 2020, during which time it’s grown over 80% so far.
However, with a recent PE ratio of around negative 40, the ark innovation ETF is looking pretty
overvalued and is also holding a basket of stocks that when combined together are not profitable.
Triple Q has an expense ratio of .2%,
which is substantially less than ARKK but still pretty high for an index fund. It offers an
annual dividend yield of about .6%, which isn’t anything substantial, but it is more than ARKK.
The returns of QQQ haven’t been quite as impressive as ARKK, but they are still significant
at 20% annualized over the last 10 years, and 30% this year. The P/E ratio of the QQQ portfolio is
approximately 47.5 as of their latest quarterly report, compared to the S&P500’s P/E ratio of
about 36 at the time of making this video. This suggests that triple Q is indeed overvalued,
especially considering people already think that the broad market is overvalued at current prices.
So when it comes down to it, are these funds a good investment? Well since
I started this video with a comparison to total market index funds, let’s start there.
I think compared to total market index funds, both of these funds are better
weighted into companies that could provide superior returns in the short-term future,
especially at a time where financial experts are predicting a lost decade of stock market returns.
And this is because they both feature innovative technology companies,
which are looking to be a safe bet in the coming years.
But, each fund does this in different ways. Triple Q uses a pure indexing approach,
which I think leaves it too heavily weighted in companies like Apple, Amazon and Microsoft,
and probably means it has a handful of holdings that aren’t fully contributing to the theme
of innovation. Furthermore, this eliminates the possibility of holding any smaller cap companies.
ARKK uses research and various principles to select its holdings,
and while I’ve wanted to avoid actively managed funds because of their inherent risks,
I really appreciate the transparency that Ark Invest has shown so far. On their website,
they have a research center where you can read up on the latest news and information
they’re using to drive their investments. You can also sign up for email notifications, and they’ll
send you daily alerts to let you know exactly what they’re buying and selling within each of their
funds. But at the end of the day, all investments require the approval of CEO Cathie Wood. So if
you’re investing in ARKK, you’re investing in her. She’s obviously done well so far, but as with any
investment, it’s impossible to draw conclusions on future returns based on previous performance.
Both funds appear to be pretty overvalued. While triple Q has a greater PE ratio,
it’s worth noting that ARKKs PE ratio is negative which shows they are making
riskier investments on companies that aren’t fully profitable yet.
Ultimately I think to invest in either of these funds, you have to believe that
innovation is going to be the driving force in the market moving forward.
If you hold that belief, you should feel confident that both of these funds
will continue to outperform total market index funds. If you’re looking for the safer investment,
I think triple Q fits the bill. It’s weighted towards the large cap technology-based companies
that have been carrying the market in recent years, which means it’ll probably be a more stable
investment as these companies have already established their position in the markets.
If you’re looking for maximum growth potential, ARKK seems well-designed to deliver on that. With
transparent, extensive research strategies and strong arguments behind their views on innovation,
I think it’s possible that ARKK will hold some of the market’s best investments in the coming years.
But, with active management, a smaller portfolio size and
the inclusion of small market cap companies, it could be a bumpy ride.
Personally, I’m going to add a small position in both of these funds to my portfolio.
I’m going to use triple Q to slightly tilt my total market holdings towards the technology
based companies that have outperformed the market lately and may continue to do so.
I’m going to add a slightly larger position in ARKK, because I really
enjoy their commitment to research and their transparency in their operation.
I’m not thrilled with the .75% management fee, but it is lower than other mutual funds on the market,
and if they continue to deliver returns that are anything like the ones we’ve seen so far,
the investment should cover those fees many times over.
To be fully transparent, QQQ is going to make up 5% of my portfolio, with ARKK comprising 10%
of my portfolio. My total market index fund allocation used to be 60% of my portfolio,
and now I am reducing it to 45% to make room for these new holdings.
Overall my decision to invest here is based on my belief that the future of the markets and
our world is going to be very different thanks to the technologies that are developing today.
Although index funds have worked in the past, I want to prepare my portfolio for the coming
technological breakthroughs that are likely going to overshadow the returns of the total
market. By adding QQQ and ARKK, I’m confident that I’ll be able to capture greater returns
than just by holding total market index funds alone.
So what’s your plan? Let me know in the comments if you plan on adding either of
these funds to your portfolio, or if you’re stock picking to create your own portfolio
of innovative stocks. And if you enjoyed this ETF breakdown, make sure to subscribe to the
channel for more videos like it. Happy investing and I’ll see you next time!