SARK - 3 Reasons Not To Invest In SARK

2023-03-31 02:32:47 ET

Summary

• SARK is a short innovation growth ETF.
• The fund has significantly outperformed since its inception.
• The future looks less rosy.

Author's note: This article was released to CEF/ETF Income Laboratory members on March 18th.

The Tuttle Capital Short Innovation ETF ( SARK ), a short innovation growth ETF, has an outstanding performance track-record, significantly outperforming since inception. Prospective returns are much lower, as short equity is almost always a losing long-term position or trade. Although SARK is a reasonable short-term trading vehicle for tech bears and the like, I'm apprehensive about the fund's returns long-term. As such, I would not consider a long-term investment in the fund.

SARK - Quick Overview

SARK is an actively-managed ETF which shorts innovation growth companies in general, ARK Innovation ETF ( ARKK ) in particular. The fund does so through the use of equity swap contracts, which entitles the fund to the daily inverse investment results of ARKK. So, ARKK goes up X%, SARK goes down X%, and vice versa. Daily returns could very slightly differ from expectations, due to fees, tracking error, and a few other investments, but significant deviations are incredibly unlikely. SARK returned almost exactly the inverse of ARKK on a NAV basis this past day, as expected. Price returns were a bit lower than expected, as discounts widened. Discounts very rarely widen significantly for an ETF, but small, short-lived discounts or premiums do sometimes occur.

SARK's investment thesis or use case is simple. The fund is short a speculative, expensive equity segment, and should see strong returns if said segment posts losses. Said segment has seen significant losses since late 2021, almost perfectly coinciding with SARK's inception. SARK has seen gains of over 70% during the same, almost exactly mirroring ARKK's losses, as expected. ARKK's losses were driven by overvaluation and worsening investor sentiment. SARK's gains compare favorably to the losses experienced by the S&P 500, as well as most other asset classes.

SARK would likely see further gains if ARKK continues to post losses, which is always a possibility. Equities in general, and ARKK in particular, have seen gains YTD, due to improved valuations and investor sentiment, so further losses are anything but certain. Still, these remain a possibility.

In my opinion, and considering the above, SARK is a reasonable trading vehicle for tech or growth bears.

SARK - Long-Term Prospective Returns

SARK's structure is such that the fund's long-term expected performance is quite mediocre, in my opinion at least. I'm expecting losses and underperformance, with a low probability of gains or outperformance. Three reasons why.

Stocks Mostly Go Up

Stock owners are entitled to their fair share of the underlying earnings, cash-flows, and net assets of their stock. These tend to be quite substantial, and underpin equity long-term returns. Short-term equity price movements might be due to sentiment, investor flows and similars, and equities might go down even if fundamentals are strong, but as long as companies are generating profits and cash long-term returns should be positive, and companies are generally profitable.

SARK is always short equity, which means the fund's long-term expected returns are negative , insofar as equities tend to have positive long-term returns. Investors might get lucky a few months, perhaps even a few years , but the long-term trend is for stocks to go up, and for SARK to go down.

ARKK Mostly Goes Up

Stocks mostly go up, and that includes ARKK, which has seen reasonably good returns since inception.

SARK's strong results were, in part, the result of good timing. The fund was created in late 2021, a few months before ARKK's share price collapsed. SARK got a bit lucky with its timing, but that might not be the case moving forward. Considering ARKK's positive long-term returns, SARK's investors should expect negative long-term returns, recent gains notwithstanding.

Structural Issues and Volatility

SARK's long-term performance could be materially weaker than expected, or than implied by ARKK's performance, due to structural and operational issues with these funds.

This might be easier to show with an example.

ARKK goes up 10%, then down 10%. Returns would be as follows.

(1 + 0.1) * (1 - 0.1) = 1.1 * 0.9 = 0.99

SARK would go down 10%, then up 10%. Returns would be as follows.

(1 - 0.1) * (1 + 0.1) = 0.9 * 1.1 = 0.99

In the example above, SARK was down even though ARKK was down too.

The more volatile ARKK is, the greater the probability, frequency, and magnitude of the above happening. Let's assume ARKK experiences twice as much volatility as above. Returns for both ARKK and SARK would be as follows.

(1 + 0.2) * (1 - 0.2) = 1.2 * 0.8 = 0.96

As can be seen above, more volatility means lower SARK returns, and this is true even if ARKK itself goes down.

ARKK is an incredibly volatile fund, so losses from the above could be quite significant.

In practice, investors would have to be terribly unlucky for ARKK to experience so much volatility in a short period of time. So, the losses above are not terribly likely in the short term . Long-term, ARKK is bound to experience a couple of days like above, decreasing SARK's returns. Due to ARKK's excessive volatility, these issues could have a significant impact on SARK's returns. As an example, SARK has been flat since May 2022, even though ARKK is down 18.3% since the same. There are many time periods around the 1y mark during which SARK has significantly underperformed the inverse of ARKK, but fund performance does vary widely (lots of volatility in these funds).

As mentioned previously, the above is unlikely to happen during shorter periods of time, but not impossible. Both ARKK and SARK were down in November 2022, for instance.

Long-term, ARKK going down does not necessarily mean SARK going up, which complicates matters for investors. For an investment in SARK to be profitable investors need to correctly predict ARKK share price movements, their volatility, and their sequence. Seems very difficult to do.

Why Does SARK Pay a Dividend

Finally, a quick explanation as to why SARK pays a dividend, a matter of some interest to some of the fund's investors.

Simplifying things a bit, investment fund distributions are regulated, and funds are generally required to distribute any income received and realized capital gains to shareholders. ETFs are structured / operate so as to minimize the buying and selling of securities, so (realized) capital gains distributions are rare. For regulatory reasons, the gains on some financial derivatives must be realized, and so must be distributed to shareholders.

As such, SARK investors should expect a significant portion of their returns, if any, to come in the form of special distributions at the end of the year. As an example, SARK saw total returns of 83% in 2022, with a massive 37% distribution late in the year.

Insofar as SARK continues to deliver strong returns, the fund should continue to distribute a lot of cash to shareholders. Distributions would almost certainly be cut if returns stall, however.

SARK's distributions are not covered by underlying generation of income, so distributions are not safe, sustainable, or dependable. As such, and in my opinion, the fund is not an effective income vehicle, nor an appropriate investment for income investors. SARK does not produce income, but it must, sometimes, distribute cash to shareholders for regulatory reasons.

Conclusion

Although SARK is a reasonable short-term trading vehicle for tech bears and the like, I'm apprehensive about the fund's returns long-term. As such, I would not consider a long-term investment in the fund.

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