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4 Lessons From ARK’s Rapid Rise—and Fall

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The strategy used by ARK Invest’s Cathie Wood, pictured, may still yield great results in the long term. But the lessons of the past year are worth heeding.
Photograph by Will Crooks

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The meteoric rise of fund company ARK Invest and its outspoken founder Cathie Wood was the biggest success story of 2020. Last year, however, was a very different story.

ARK Innovation (ticker: ARKK), the firm’s flagship fund, peaked in February 2021. As we near that anniversary, the fund is down 52% from the peak. This is bad news for recent investors in the fund, but there are lessons here for everyone.

The nine ARK exchange-traded funds, which have a total of $23 billion in assets, all embody Wood’s investing philosophy: Buy businesses with disruptive innovations that could revolutionize how people live and work—such as electric-car maker Tesla (TSLA), digital-payment company Square (SQ), and remote-healthcare platform Teladoc Health (TDOC). Wood, ARK’s founder and CEO, is a firm believer in the exponential growth of these companies, and has repeatedly set high price targets for them and bought more shares when prices have dropped, as she did with Robinhood Markets (HOOD) earlier this week.

The Covid-19 pandemic accelerated the adoption of many emerging technologies in 2020. Innovation stocks surged, and ARK’s five actively managed ETFs returned an average of 142% that year—performance that attracted a whopping $20 billion in inflows in 2020 and another $17 billion in the first two months of 2021. But things took a sharp turn since the ARK funds peaked that February, and rising inflation and the prospects of Fed rate hikes has made the future cash flow that innovation investors bank on less valuable today. ARK Innovation, which soared 157% in 2020, lost 25% in 2021. The fund is down an additional 20% year to date.

Wood’s strategy may still yield great results in the long term, but the lessons of the past year are worth the attention of all investors.

Be Wary of Outsize Gains

It’s highly unlikely for any fund to post chart-topping returns year after year. According to data from S&P Dow Jones Indices, about 30% of large-company stock funds beat the S&P 500 in the 12-month period ended June 2019. But only half of those outperformers were able to do it again in the next 12 months, and only 12% maintained their streak over three consecutive years.

In fact, funds that shoot up considerably in a short period of time are typically making very concentrated bets, which means their downfall could be similarly dramatic when market trends reverse course. The performance of ARK Genomic Revolution (ARKG), for example, has been all over the map. The fund was in the bottom percentile among healthcare funds in 2015, jumped to the 4th percentile in 2017, fell to the 50th percentile in 2018, made the top in 2020, and fell back to the bottom in 2021.

Don’t Chase Momentum

Investors’ actual returns (known as dollar-weighted returns) are often worse than the stated returns of the fund itself, because investors tend to go in after many gains have been made and get out too late. Major cash flows into ARK Innovation didn’t kick in until late 2020, which means most shareholders didn’t fully benefit from the fund’s triple-digit gains that year. Meanwhile, many have sold their shares over the past six months as the fund kept falling, further reducing their gains or deepening their losses.

Morningstar analyst Amy Arnott estimates that the average dollar invested in ARK Innovation lost 12% in the 12 months prior to December 2021. That’s almost three times deeper than the fund’s 4.3% decline over that span. In the three years prior to December 2021, investors received an annualized 10% return, less than one-third of the fund’s 35% gains during the period.

“This is classic investor behavior, chasing the hottest stocks right at the wrong time,” says Blair duQuesnay, a financial advisor at Ritholtz Wealth Management. “With all the money flowing into these five-star-rated funds, it’s usually a sign that underperformance is coming.”

Beware Overlap

Chasing winners has another peril: Hot funds that seem different often own very similar stocks. ARK Innovation and the ARK Next Generation Internet (ARKW), for example, have two-thirds of their holdings in common, while ARK Space Exploration & Innovation (ARKX) and ARK Autonomous Technology & Robotics (ARKQ) share nearly half of their portfolios. Owning these funds together makes for a less-diversified portfolio than investors might think.

This is quite common, even in broader index ETFs: The Consumer Discretionary Select Sector SPDR ETF (XLY), for example, is commonly used to make a broad sector bet—though it has an 18% weight in Tesla. Adding the ARK Autonomous Technology ETF, which has 10% in Tesla, would give a portfolio an even larger exposure to the electric-auto maker.

Assess Your Risk Tolerance—Honestly

Concentrated and volatile funds like ARK’s aren’t for everyone, even if they believe in the innovation. Investors need to trust the manager’s skill to pick the winners in these quickly evolving industries, and have the stomach, patience, and financial flexibility to hold through difficult times—which even the most talented stockpickers will encounter. More importantly, these funds should never make up the majority of a portfolio; they are a complement to diversified core holdings.

“The innovation companies are early in their business lines and a lot of them don’t have any earnings today, so their valuations are always very subjective,” says Ryan Jacob, manager of the $107 million Jacob Internet fund (JAMFX), which invests similarly to ARK. “There will be periods when these stocks come in and out of favor, and last year was just a microcosm that saw both ends at extreme.”

Write to Evie Liu at evie.liu@barrons.com

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