Almost every Ark fund is now underperforming the overall market. Here’s why.

Are you a fan of Cathie Wood’s Ark Invest exchange traded funds? You are not alone. She and her company made quite a name for themselves in 2020, when many of these ETFs easily outperformed the already bullish market. It was a time when investors readily embraced — and bid for — the shares of companies with new business ideas. The Ark Fund owned a bunch of these names.

However, things have changed since 2021 and not for the better. Although the S&P 500 (^GSPC -0.32%) and the Nasdaq Composite (^IXIC -0.85%) are both within sight of recent record highs, most Ark funds are still trading well below their 2021 peaks. In one example, the Ark Genomic Revolution ETF (ARKG 0.04%) has fallen more than 20% over the past five years, compared to roughly doubling the market value.

What went wrong? Nothing went wrong, per se. Ark funds are still exactly what they should be.

There is the problem though because in this market environment, what they are is exactly the wrong thing.

The Ark Funds were hot… until suddenly they weren’t

In case you’re reading this and aren’t familiar with them, Ark Invest manages a family of exchange-traded funds designed to “focus exclusively on investing in disruptive innovation.” Each fund simply focuses on a different area of ​​innovation. The Ark Fintech Innovation ETF (ARKF -0.76%)for example, it owns some of the most promising fintech stocks on the market. Flagship Ark Innovation ETF (ARKK -1.10%) consists of a wide range of tickers. Its biggest holdings right now are the electric vehicle maker adzeoutfit with streaming technology Rokucryptocurrency wallet company Coinbase Globaland video game/metaverse platform Roblox. The aforementioned Genomic Revolution ETF of course invests in gene technology and therapy companies.

These are all promising industries, each of which hosts at least a few compelling investment prospects. Many of these prospects have had good (if erratic) results throughout their history. Actually, most of Ark funds rose immediately as the market began to recover from the pandemic-induced downturn in early 2020.

However, these rallies have taken off since 2021 and have never really stopped, even as the market tide turned decidedly bullish again early last year.

^ SPX data by YCharts

What gives?

The fault is not in the premise of investing in disruptive technologies. The fault lies in the execution of the idea and the fact that such funds are apt to perform well only in certain types of economic environments.

Ark Fund’s outsized risks come back to haunt investors

Hot tech stocks are the obvious favorites of aggressive, growth-oriented investors, and for good reason. Over the long term, this is where the biggest market gains tend to come from.

However, these large gains are recorded rather inconsistently. They usually require a very particular economic environment. This is one marked by low interest rates (which creates cheap growth capital) and a robust economy like the tech-driven one seen in the late 1990s and the stimulus-driven one in 2020. Any less, and tech stocks aren’t particularly of good -positioned to thrive. Even Cathie Wood says so. In a recent letter to Ark fund owners, Wood admits that “Ark strategies, starting with ARKK, have paid the dues associated with higher interest rates.”

As for the execution of the idea of ​​only owning shares of potentially disruptive companies, this is where the criticism gets a little philosophical.

Perhaps first, while each of Ark’s ETFs is industry-focused, Wood and Ark’s fund managers don’t buy and hold stocks and then let time do most of the heavy lifting. They trade quite frequently, even if they limit a particular fund’s trades to stocks in an allocated industry. The Ark Next Generation Internet ETFhis (ARKW -1.54%) The most recently reported annual turnover, for example, is 33%, meaning that a third of the portfolio’s stocks were traded for others in the 12-month period in question. Not only does this above-average turnover increase a fund’s annual tax potential, it can reduce performance. The data consistently shows that funds designed to outperform the general market by buying and selling stocks more frequently actually underperform more often than not. Trading time is just hard to do!

In this regard, it would be remiss not to point out that (too) much of Ark’s buying and selling appears to be reactive rather than proactive, when much of the opportunity in question is already in the rearview mirror.

And it’s worth adding that most Ark ETFs aren’t necessarily well balanced. Tesla accounts for slightly more than 13% of the Ark Autonomous Technology & Robotics ETFhis (ARQ -1.43%) value, while the second largest represents more than 10% of the fund’s value. It is not a great diversification. Also know that while Tesla is a major piece of the Ark Autonomous Technology & Robotics ETF, the electric vehicle company also accounts for more than 13% of the value of the Ark Innovation ETF, highlighting the risks of overconcentration for the family ETFs Ark as a whole.

Also, let’s not pretend that a wide range of Ark picks pounced on actual potential returns rather than empty, unproven hype.

The net end result? Total underperformance for long periods of time. Any Ark fund that’s been around long enough to be comparable currently lags the S&P 500 on three- and five-year terms.

A good allocation strategy at least works in most environments

None of this suggests that the Ark funds cannot or will not thrive again in the future. I might. Indeed, they probably will.

However, even patient buy-and-hold investors cannot ignore the fact that staying patient with these funds translates into a major missed opportunity in the meantime. Again, the Nasdaq, as well as the S&P 500, both hit record highs recently, while some (probably too many) Ark funds linger near multi-year lows. A sound allocation strategy should capture at least most of the market’s gains most of the time. And perhaps that’s the most important takeaway for investors — most people don’t have a few years to wait and hope that an industry-focused bet will work. Sometimes I don’t go out at all. Just ask most meal kit companies…the ones that are still around.

It’s just something to think about if you’re trying to figure out how you feel about Ark’s aggressive, industry-focused approach to stock picking.