IDNA - ARKG ETF: An Enticing Play But Risks Galore

2023-09-28 11:15:57 ET

Summary

• The ARK Genomic Revolution ETF is a $2bn actively managed ETF that focuses on companies leveraging genomics in their products and services.
• Genomic-based applications have the potential to revolutionize healthcare and address modern-day illnesses.
• ARKG is an expensive and risky offering with high costs, high valuations, an elevated volatility profile and heightened sensitivity to the broader markets.
• On the charts the risk-reward looks to be in a better place, but investors are advised to wait for signs of bottom formation before loading up.

ETF Snapshot

The ARK Genomic Revolution ETF ( ARKG ) is a $2bn sized actively managed ETF that seeks to profit from the growing stature of the genomic revolution. Note that the companies that belong to this portfolio (typically 40-60 names at any given time) come from different industries, including healthcare, tech, consumer discretionary, materials or even energy, but what’s common, is that there’s an underlying thrust to leverage the interdisciplinary field of genomics, and incorporate that into the products and services they offer.

The Genomic Revolution Is Here To Stay

Genomic-based applications have the potential to offer a more comprehensive understanding of some of the modern-day illnesses that afflict mankind. Take for instance, when the COVID-19 pandemic first visited our shores, genome sequencing was put to good use and played an instrumental role in isolating the SARS-COV-2 virus. In fact, the WHO is on record stating that “accelerated integration” of genome sequencing within global health practices will be fundamental if we are to mitigate future health threats.

In fairness, this is not something that germinated only yesterday, and branches of the genomic revolution have been making tenuous inroads for a while now; for instance, given their specialized ability to tweak the structure or function of RNA (Ribonucleic Acid) and other molecules, RNA-based therapies have often been relied on to address undruggable targets. This has prompted a significant spurt in the number of RNA-based therapies in clinical pipelines (currently estimated to be over 500)

Besides the efficacy angle, there’s also the relative timeliness and cost competitiveness which will only magnify its adoption. Relative to antibody or small molecule trials (10 years on average), RNA-based development is typically a lot shorter (5 years on average). Inevitably this also results in lower clinical development costs of almost 40% compared to other modalities.

It isn’t just RNA-based therapies that are worth highlighting. Dysfunctional proteins in our bodies too often need to be dealt with, and here something like Targeted Protein Degraders (TPDs) can be very effective perspective (relative to traditional small molecule inhibitors) as one single TPD molecule can degrade a larger number of target proteins.

ARKG- An Expensive And Risky Offering

Considering ARKG is an actively managed product, costs can be quite prohibitive; for context, ARKG’s expense ratio works out to 0.75%, whereas other competing passively managed ETFs in this space, such as the iShares Genomics Immunology and Healthcare ETF ( IDNA ), Invesco Biotechnology & Genome ETF ( PBE ), or the Global X Genomics & Biotechnology ETF ( GNOM ) can all be accessed at a much lower expense ratio range of 0.47%-0.58%.

Then, ARKG’s valuations could also be off-putting to some. According to Morningstar, ARKG’s holdings currently trade at a weighted average P/E of 33x . It’s quite remarkable that ARKG even generates some semblance of aggregate earnings to be valued at the P/E level, given the status quo with the top 10 stocks of the portfolio which jointly account for half the total portfolio. As you can see from the image below, except for Schrodinger, Inc. ( SDGR ), none of the other top 10 stocks currently generate any positive earnings on a trailing twelve-month basis. Thus, given the low aggregate denominator effect (limited earnings), one can understand why ARKG’s valuations will come across as pricey, even if it has lost over half its value over the last three years.

It’s also fair to say that if you’re someone who prefers to build steady wealth, and are attracted to avenues of stability, ARKG is probably not meant for you. Note that one in every two stocks from the portfolio get turned over every year (for the average ETF the annual turnover rate is typically one in three).

Then, ARKG’s promoters also believe that this product could perhaps serve as a niche portfolio play offering useful diversification effects relative to the traditional side of the market, but if one reviews this ETF’s sensitivity quotient relative to the broader markets, one would have to disagree.

As captured in the image above, over the last five years ARKG's sensitivity to the benchmark has been very strong, with a beta of over 1.5x. On the other hand, if one were to consider the sensitivity quotient of a biotech portfolio (SPDR S&P Biotech-XBI), you’d see that it moves more in tandem with the broader markets.

It’s also worth noting that the returns you generate on a monthly basis could be subject to considerable volatility. That wasn’t quite the case during ARKG’s initial years in the markets, with the annualized standard deviation of its monthly returns coming in at low single-digit levels; nowadays that figure is at double-digit levels. Conversely, when it comes to something like XBI, which also dabbles with high-risk plays, the overall volatility profile of the portfolio has remained relatively consistent over time.

Closing Thoughts- Technical Considerations

The Genomic revolution certainly has legs, but as noted in the previous section, dabbling in this sector is also certainly not meant for the faint-hearted. If you feel like you have the stomach to deal with what this sector will throw at you, then do also note that the risk-reward on the charts is now in a better place.

The chart below highlights how ARKG’s brand of stocks are positioned relative to the broad biotech universe. A couple of years back the ratio looked very overextended to the upside, but the ratio has more than mean-reverted since and is now trading within the lower half of the long-term range.

Then, if one were to investigate different parts of the market, you’d note that micro-caps currently account for the most oversold sector of the broader markets, and could see some mean-reversion. Note that the microcap to total stock market ratio is currently at record lows and a long way off the mid-point of the long-term range.

On ARKG's own weekly chart, it appears that the ETF has been chopping around within a certain range for around one and a half years now. Considering where the price is currently, it's fair to say that the reward-to-risk equation looks quite favorable with ARKG hardly a breath away from the support zone.

Having said that, we’d advise investors to observe the price action near the lower boundary over the next few weeks to see if it can flatten out there. We say this because since late July, the ETF has been subject to the classic lower-low/lower-high sequence, and particularly over the last three weeks this has only magnified. Also note that the quantum of fund outflows over four out of the last five weeks have also been quite sizeable.

Put another way, you don’t want to stand in front of a speeding train. Wait on the sidelines for now and see how the ETF reacts when it hits the support zone.

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