Look, we have to talk about Cathie Wood and the ARK Disruptive Innovation ETF, but we
are going to try to be nice.
Things have not been going well for ARKK investors.
The ETF has had a bad year so far in 2022, where it has lost almost half its value.
2021 wasn’t so good either where the Disruptive Innovation ETF lost just over 22%.
Tech stocks in general did quite well that year, with the Nasdaq up 27.5%, which made
the ARKK funds’ performance even more surprising – and disruptive…
Now most of the investors in the ETF are of course doing a bit worse than Cathie Wood,
the fund manager, as Cathie has a few advantages over them.
First, she invested in her fund on day one, and since inception the fund has had positive
returns, and apart from its extreme volatility, its overall performance has been roughly in
line with the S&P500.
Most investors unfortunately didn’t invest on day one along with Cathie.
Bill Hwang did, but the recent sell off in ARKK is in truth the least of his problems.
If he is still invested, it might be one of his best investments over the period in question.
Most investors we find, invested in late 2020 and in early 2021, and for that reason most
of them are deep underwater right now.
So, why didn’t they invest on day one?
Well, for one thing they hadn’t heard of the EFT on day one.
They heard of it after it delivered returns of more than 150% in 2020.
It was all over the news at the time, and all over YouTube too.
Now, it might surprise you that 2021 will have been a much better year for Cathie than
2020 was, when the fund was up more than 150%.
This is because the Disruptive Innovation ETF Started out 2020 with less than 2 billion
dollars in Assets Under Management.
The management fee is seventy-five basis points, so fees would have been under 15 million dollars
on that asset base.
At the peak in 2021 fees would have been over 200 million dollars, and this is because so
much more money had come in, so not a bad year for Cathie and her team, even if the
fund was down in an up market that year.
Alongside the disruptive innovation ETF Ark invest has 10 other investment vehicles dedicated
to themes from cryptocurrencies to space exploration, they mostly have similar performance and similar
fees, so overall assets for the company peaked in February 2021 at over sixty billion dollars,
so in terms of fees, 2021 – the year in which they started losing money would have
been – by far - their best year.
It would appear that less than 40 people work at ARK invest, most of whom are quite young
and have very little prior financial experience, so, it is a good guess that the lion’s share
of profits will have gone to Cathie.
So, is there anything we can learn from this?
Well, there are actually quite a few lessons here.
One of which I take from one of my favorite investing books, Market Sense and Nonsense
by Jack Schwager.
In the introduction to the book, he tells the story of an early job he had working as
a research director for a big Wall Street Brokerage firm.
One of his responsibilities was to evaluate CTA’s – a type of investment fund.
One of the statistics that CTA’s were required to report by their regulatory authorities
was the percentage of client accounts that closed with a profit.
Jack describes in the book how surprised he was to discover that the majority of closed
accounts showed a net loss for virtually all of the CTA’s he reviewed – even those
with virtually no losing years.
How could this happen?
Well, the answer is that investors – on average – are so bad at timing their investment
entries and exits that most of them end up losing money – even when they chose a consistently
winning fund to invest in.
They do this by buying after periods of good performance and panicking and selling during
drawdowns.
Now, this instinctive approach to investing might feel perfectly natural, even instinctive,
but it turns out that it is generally wrong.
We can look at the fund flows for the Ark Disruptive Innovation ETF since inception,
and you can see the green lines are money flowing into the fund, and the red lines are
money flowing out.
I chose this fund, not to pick out someone who is underperforming right now, but because
it provides a really vivid example of the mistake investors make in chasing performance.
You can see that not much happened in terms of fund flows for the first few years and
then all of the money came in right after the fund performance peaked.
If we look at the same chart for an S&P tracking ETF, you can see similar behavior where investors
buy after periods of good performance and sell after periods of bad stock market performance.
It is less obvious with an S&P tracker just because the tracker is considerably less volatile
than ARKK and it won’t have attracted nearly as much attention as the Disruptive Innovation
ETF did.
Based on these fund flows, you can see that, while Ark Disruptive Innovation has had similar
long term percentage returns to the overall market since its inception.
In dollar terms, the team at Ark Invest have lost way more money than they ever made for
clients.
This ETF is up in percentage terms since inception but overall, it is a net contributor of money
to the market – a destroyer of wealth.
A gain of 150% on two billion dollars, followed by a loss of 70% of 60 billion dollars is
just not a good thing.
There is a long history of funds like this, a good example being the Munder NetNet fund,
which was a dot com mutual fund from the late 1990’s.
The NetNet fund returned around 175% in 1999 and its assets under management ballooned
to more than $11 billion by spring 2000 right as the dot com bubble burst.
As tech stocks fell in 2000, the fund lost 54%, The next year it lost an additional 48%.
Between investment losses and investors withdrawing their money, NetNet shrank to $1 billion in
assets under management in late 2001.
This wasn’t the end though; the fund went on to lose an additional 45% in 2002.
In 2005 the fund manager stepped down.
Much like Ark Invest, Munder had a number of additional funds to feed investor enthusiasm
for dot com stocks.
There was the Munder Digital Economy Fund, The Munder International NetNet Fund and The
Munder Future Technology Fund.
Research shows that in general fund investors underperform the funds they invest in, and
they do this by chasing returns.
A paper by Dalbar, Inc. showed that over a twenty-year period, the S&P 500 returned just
over 6% a year, but the average equity fund investor achieved a return of only 4.25%.
They found that the average investor buys after a price rise, and then fails to stay
invested in any given fund for a long enough period of time to realize the long-term benefits
of asset ownership.
Digging deeper into Jack Schwager’s book, he discusses how any search for the top performing
mutual fund will usually return a list of sector funds as there will always be one stock
market sector that is outperforming the broad market.
He then looks at what happens if you invest in the recently best performing sector, the
recent worst performing sector, or the overall average.
Generally, it turns out to be a mistake to invest in last year's best performing sector.
He also looks at 140 years of US stock market data and finds that the periods of highest
returns come after periods of low returns.
Baron Rothschild, an 18th-century British nobleman, is credited with saying that “the
time to buy is when there's blood in the streets.”
Rothschild followed his own advice and made a fortune buying in the panic that followed
the Battle of Waterloo.
Ok, so are there any other lessons we can take away from the rise and fall of the Ark
disruptive innovation ETF?
Well, one vulnerability in Ark’s model is that the ETF often has very concentrated positions
in smaller companies.
The problem with this is that as investors add money to the ETF, this money is used to
buy shares in these small companies which then pushes the stock prices up.
Ark Invest often owns more than 10% of the companies they invest in.
The problem then is that if the ETF underperforms, and investors start redeeming their shares,
the exact opposite happens and the selling can push down share prices, hurting performance,
driving even more selling.
One example of this issue is Proto Labs, a 3D printing company.
Ark Invest built up a 15 per cent stake in the company and the buying pressure helped
to push its market value from less than $3bn at the start of 2020 to a peak of almost $7bn.
But when Ark Invest began cutting the stocks weight in their ETF, the stock price collapsed.
It has fallen 75% from its peak today.
The dangers of illiquid investments are highlighted by the story of Neil Woodford - once lauded
as “the man who can’t stop making money” and “Britain’s Warren Buffett”.
In June 2019 he was forced to suspend trading in his £3.7bn Equity Income fund after being
unable to cope with a surge of investor redemptions.
The Woodford situation was more extreme than Ark Invest – as many of the companies he
invested in were totally illiquid.
The UK markets regulator, the FCA, said at the time of the suspension that a fifth of
the fund’s assets were in extremely illiquid assets, many of which didn’t trade at all.
Ark rose to prominence during the Covid pandemic, a time characterized by retail trading, meme
stocks and cryptocurrencies, with many online investors using Twitter and Reddit to exchange
ideas.
By getting involved in social media and freely sharing Ark’s research, Wood developed a
cult following amongst a younger audience of investors.
Ark’s website even has a store where you can buy merch.
Cathie made bold predictions about the valuation of companies she invested in which drew a
lot of attention on social media.
She predicted that her ETF would generate annualized returns over the next five years
of 50%, something that has only been achieved by one registered investment company since
records began, and that was a 3 times levered fund.
She announced that GDP growth would reach 30-50% a year due to breakthroughs in artificial
intelligence.
I don’t know what to tell you about that… she is an optimist, i guess…
She posted a YouTube video in 2020 of five industries that investors should avoid.
They have all outperformed her ETF by now.
Let’s look at the comments on that video…
Oh Stacie…
Wait, what is the reply…
Oh John…
Investors haven’t yet really started selling the Ark Disruptive Innovation ETF.
In fact, in the first half of this year it saw 1.5 billion dollars in inflows according
to TrackInsight, but the ETF’s fall from grace has brought about a growing army of
short sellers and the short interest in the ETF is over a billion dollars.
It is argued that investors have not yet dumped the ETF as over the last few years they have
been conditioned to always “buy the dip” – after all, Stonks only go up.
If you enjoyed this video, you should watch my video on investing in an inflationary environment
where I look at how various asset classes perform when central banks are hiking rates.
See you next week, bye.