Why ARK Invest Needs to Be in Your Portfolio

 

ARK Invest is a newer kind of investment fund just now beginning to gain notoriety. The fund is an actively managed ETF (exchange traded fund), unlike most ETFs that are passive index funds. This kind of fund is managed in a similar way to a mutual fund but is traded on the open market like an ETF. But what is more interesting about ARK Invest is their investment philosophy. Most ETFs and mutual funds focus on mimicking an index (e.g., S&P 500), or investing in a particular sector (e.g., energy) or market cap (e.g., small growth). ARK Invest, instead, focuses on the theme of disruptive innovations across all indexes, sectors, and market caps. 

Since inception, ARK Invest has produced annualized returns between 19% and 33%. If those kind of returns can be sustained then they would rival the 20% annual returns of Berkshire Hathaway. Such success deserves a closer look.

There are five areas of disruptive innovation that ARK Invest pursues: Energy Storage, Automation, Next Generation Internet, Blockchain, and DNA Sequencing. Energy storage will change the way the world consumes and stores energy and includes companies like Tesla. Advances in automation and robotics will soon allow robots to begin working side by side with humans, increasing human efficiency. Next generation internet and artificial intelligence will allow companies to make smarter economic decisions as they are able to more efficiently process customer data to produce better products that consumers want. Blockchain is a secure method of financial transaction that allows people and businesses to transfer currency without traditional banking networks. DNA sequencing is the next step in medical advancement and may lead to cures for many diseases. 

ARK Invest believes that this is the first time in history that five distinct, world changing innovations have come together at the same time in history. The last time that multiple innovations occurred near the same time was the late nineteenth century with the combustion engine, telephone, and electric lighting. Those three innovations propelled industry throughout the twentieth century. The five disruptive innovations of today is likely to propel industry into the next century. 

 

In 2016, two years after ARK Invest began, CNBC wrote an article warning readers about the dangers of theme-based investments. In the article, Andrew Holland, a portfolio manager at Quantitative Investment Advisors indicated that investments like ARK Invest did not serve any well founded investing purpose. His suggestion was that investors looking for aggressive growth strategies turn to more traditional long term investments such as emerging markets. 

When the article was written, the S&P 500 had a -6.1% YTD return while the three ARK Invest funds noted in the article had YTD returns of -19.8% (ARKG), -15.6% (ARKQ), and -18% (ARKW). Based on these numbers, it is no wonder that the article painted these investments in a negative light. However, ARK Invest is very clear about its short and long term outlooks. Their philosophy is that over the short term there will be price volatility but over the course of a five year time horizon they will beat the market as they invest in innovative companies early and at a discount. This is simply the reality of investing in innovation. Such companies tend to fly under the radar until they reach a tipping point when the broader market begins to understand their real potential. 

So, what were the returns for ARK Invest since 2016? Did they beat the market over its five year time horizon? Below are the results.

During the same time the total return of the S&P 500 has been 10.32%. For every ARK Invest fund that was active since 2016, the return was 84% to 224% greater than the S&P 500. The average return for emerging markets, which Andrew Holland suggested investing in was a measly 4% over the same time period. This, of course, is no indicator that these funds will perform in the same way in the future. Nevertheless, the prognosticators misjudged the potential of the ARK Invest funds by a large margin.

How then does ARK Invest manage to find investments that significantly outperform the markets? It includes more than just finding companies that produce disruptive innovations. There is a rigorous methodology that they employ to assess market potential, cost curves, and customer demands among other things. Just because a company is involved in disruptive innovations does not qualify them for the ARK portfolio. The company must be financially stable and at a point where their service or product is ready to be widely adopted by consumers and businesses. Only when a company's innovative product and price are on the cusp of mainstream adoption, does ARK add them to their set of portfolios. This positions ARK Invest behind venture capitalists but in front of the larger public market. Through careful analysis they are able to purchase companies before the stock price begins growing exponentially, maximizing their returns.

In addition, ARK Invest looks for longer-term investments. That is, they want to find companies that are likely to produce excess returns over longer time horizons. They do not chase companies that just produce a flash in the pan. Since the general market is short-term oriented and looks to invest in companies that produce some return right now, this leaves companies, whose price curves are not quite ready to break out, able to be bought at a discount. This results in extra gains for those willing to wait out the short-term. 

The current focus on passive index funds also helps ARK Invest. Much of the stock market is currently bought through passive index funds. When a person invests into an index fund, the cost is generally spread throughout the index evenly. This creates price inefficiencies because all companies gain a piece of the pie through index fund purchases without consideration for future revenue potential. ARK Invest takes advantage of this price inefficiency and purchases innovative company stock at a discount just before the broader market realizes the real value. When institutional and retail traders begin buying these companies in greater volumes stock prices rise, benefiting ARK Invest as the early adopters.

Another way that ARK Invest distinguishes itself is how its analysts look at the market. They are not limited to a specific sector or market capitalization like most investment firms. Instead, they focus on areas of innovation across sectors and market caps. When a typical analyst is comparing the market share of one company to another in the same sector, an ARK Invest analyst is looking at how disruptive innovations in one sector might have an effect in other sectors. This allows them to identify areas of growth that typical analysts miss and therefore they are able to identify companies with greater growth potential before typical analysts. 

For instance, when the term blockchain is used, it is often in reference to Bitcoin and cryptocurrencies. But that is a narrow perspective of how blockchain can be used in the broader market. Blockchain technology could easily displace companies such as Visa or Mastercard by removing the need of the middle man function between a bank, a business, and a consumer. By removing the middle man, the cost of the transaction is reduced for the bank and the business, increasing their profits and additionally reducing costs to the consumer. By viewing blockchain as only a cryptocurrency technology, a narrowly focused analyst misses the total potential of the new technology and may ultimately miss out on the available returns from a company that specializes in blockchain technology. 

Before you think that ARK Invest is the greatest thing since sliced bread, it would be wise to consider the risk. The six year track record of ARK Invest is impressive, but it is only a short, six year track record. Disruptive innovations, though having great potential, may never materialize (see the tech bubble of the late 90s). It is entirely possible that this recent boom in returns is simply luck. Future returns may not be as electrifying. In fact, 33% annualized returns seems all but impossible to sustain when the overall market is only returning 10% a year. Many also call this kind of investment more speculative than aggressive. And everyone knows speculation is dangerous . . . right?

The question then should be asked, is there reason enough to believe that ARK Invest is more than speculative and can continue to find under-priced companies in innovative areas moving forward? The answer to that would only be a guess, but it would be an educated guess. The founder of ARK Invest, Catherine Wood has been investing in innovation for over 40 years and has a strong track record of success. In addition, the methodology that ARK Invest employs to identify companies for their portfolio is more robust than many other investment firms. They do some serious homework before adding a company. Finally, they provide an enormous amount of information to the public about their investment philosophies, the companies they invest in, and exactly why they invest in those companies. It is, by far, one of the most transparent investment firms I have seen. When there is objective, vetted, reasons to invest in an innovative company, that is not speculation, it is smart.

Should you invest in an ARK Invest fund? Yes. I own ARK funds in my personal portfolio. Every portfolio should include some aggressive growth funds. The percentage of aggressive growth funds in your portfolio has to be a personal decision based on your understanding of the markets and your willingness to take on volatility and risk. It is possible to lose money. Nevertheless, based on the potential risk to reward ratio for ARK Invest funds, every portfolio should consider these funds as part of their aggressive allocation. 

References

ARK Invest. (n.d.). Investor Resources. https://ark-funds.com/investor-resources

ARK Invest. (2020, June 30). Why invest in disruptive innovation. https://research.ark-invest.com/hubfs/1_Download_Files_ETF_Website/Investment_Case/Investment%20Case%20For%20Disruptive%20Innovation.pdf?__hstc=6077420.2298e395d51f2c7c368c9efdf4c669e9.1597320488255.1597320488255.1597323183516.2&__hssc=6077420.25.1597320488255&__hsfp=183078399

Bowman, J. (2019, December 22). 5 reasons Warren Buffet didn't beat the market over the last decade. The Motley Fool. https://www.fool.com/investing/2019/12/22/5-reasons-warren-buffett-didnt-beat-the-market-ove.aspx

Bloomenthal, A., (2016, February 6). Millennial investors: Maybe time isn't on your side. CNBC. https://www.cnbc.com/2016/02/06/millennials-beware-of-this-investing-pitch.html

Van de Walle, J. (2020, January 8). Expected returns in emerging markets. https://www.theemergingmarketsinvestor.com/expected-returns-in-emerging-markets-2/#:~:text=Investors%20in%20emerging%20market%20stocks,decade%20on%20a%20positive%20note.&text=As%20the%20chart%20below%20shows,33%25%20for%20the%20MSCI%20EM.