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The ARK Innovation ETF, the flagship exchange-traded fund (ETF) of ARK Invest CEO Cathie Wood, just reached an intriguing moment. In terms of performance over the last two years, it has fallen short of the Nasdaq Composite. The ARK Innovation ETF, which more than doubled in 2020, is now down 54% from its all-time high, while the Nasdaq is down 15% from its all-time high. Furthermore, as of this writing, the ARK Innovation ETF is lagging the Nasdaq Composite by around 24 percentage points over the most recent three-year period.

Big Misses

Only one of the top ten holdings in the ARK Innovation ETF – Tesla – had outperformed the Nasdaq in the previous year as of Jan. 13. The top ten holdings account for 54% of the ARK Innovation ETF. 

Tesla, Zoom Video Communications, Teladoc Health, Roku, Coinbase Global, Unity Software, Spotify Technology, Exact Sciences, Twilio, and Block are among them. Coinbase is not included in the one-year chart below since it went public in April 2021; it has fallen nearly 30% since then. 

The majority of the top ten holdings are unprofitable or slightly profitable growth businesses that grew significantly at the pandemic’s peak in 2020.

However, by 2021, many of these growth brands had been abandoned by investors, who preferred a philosophy of growth at a fair price over growth at any price. 

Consider that the top ten biggest S&P 500 components as of the end of 2021 gained about 50% on average in 2021. These are large corporations such as Apple, Microsoft, Alphabet, and other well-known technology names that are also extremely lucrative. 

In the near term, ARK’s plan isn’t working. 

It would have been extremely difficult to outperform the market in 2021 if you did not possess the top ten stocks in the S&P 500, given that these businesses provided the majority of the index’s gains. However, investing in a large tech stock is not ARK’s investment strategy.

Rather, it seeks paradigm-shifting growth equities with huge potential that have the ability to transform sectors over the next few decades. 

ARK’s method works best when investor optimism and patience are high – and interest rates are low – since such conditions favour the sorts of firms in which its funds invest. Investors have also grown tired of certain of the funds’ components. Meanwhile, the Federal Reserve is now projected to begin raising interest rates as early as March, with three to four rate rises expected this year. Rising interest rates and stricter monetary policy are significant challenges for growth firms that already have high price-to-sales ratios. Many of ARK’s assets must demonstrate persistent strong growth to justify their values.

That’s a more difficult challenge to achieve when borrowing money is more expensive – and labour and product prices are rising due to inflation. 

Given all that investors are considering, as well as a bigger proportion of smaller, unprofitable growth businesses relative to the Nasdaq Composite, it’s not unexpected that the ARK Innovation ETF has slid from outperforming to underperforming the Nasdaq.

Lessons Learnt 

The troubles of the ARK Innovation ETF demonstrate how difficult it may be to outperform the stock market. However, they also demonstrate how themes may shift from popular to unpopular in an instant owing to reasons outside a company’s control. 

You may argue that the value of companies like Zoom or Roku should not be significantly different now than it was a year ago. Despite the fact that the economy has reopened, both firms (and the sectors they are a part of) continue to develop at amazing rates, albeit at a slower pace than the record-breaking pace established in 2020. The long-term investing thesis hasn’t altered, but Wall Street’s perception of these firms has.

Similarly, investors have altered their thoughts about oil and gas companies, which have gone from the worst-performing sector to the best-performing sector in 2021. And the energy industry has already increased by more than 10% in 2022. 

The lesson here is that attempting to get into “what’s working” in the market and sell what isn’t is typically a recipe for disaster. Investing in excellent firms that you understand, believe in, and are comfortable retaining through good and bad times, on the other hand, allows your investments to compound over time. However, if your investment thesis changes, such as the firm losing its competitive edge or new technology rendering its products or services outdated, it may be time to sell.

For many investors, the risk-reward profile of many of Wood’s recommendations is just too severe to make them staple assets in a portfolio they are comfortable owning. 

However, if you believe in the firms represented by the ARK Innovation ETF and can stomach the volatility, a decline in its price might represent an excellent chance to purchase.