ARKK - Don't Bet Against Progress

2023-11-01 09:00:00 ET

Summary

• Shorting or hedging against companies driving innovation and growth in the US stock markets is not a viable long-term strategy.
• Historical trends suggest that bear markets are relatively short-lived, and positive trends in the market indicate potential long-term growth for large firms and disruptive innovators.
• ETFs that bet against innovation and growth are likely to underperform their benchmarks in the long term. It is better to invest in stocks of innovative firms and funds tracking major indexes.

Introduction

There are ETFs that short or otherwise hedge against companies spearheading corporate and financial growth, technological innovation, and progress in general in the US stock markets. Two such ETFs demonstrate why this is a bad idea as a long-term strategy. One fund, the AXS Short Innovation Daily ETF or SARK ( SARK ), is betting against the ARK Innovation ETF ( ARKK ), a fund centered on tracking select innovative companies; the other fund, the AdvisorShares Ranger Equity Bear ETF or HDGE ( HDGE ), is betting against the S&P 500 ( SPX ) ( SPY ), an index of established mid- and large cap businesses.

To be fair, the firms and individual investors who invest in these short and inverse funds likely only do so as short-term plays. If you are one of these short-term investors, feel free to ignore the rest of this article. For anyone who instead believes these are solid long-term plays, keep reading…

Historical and Present Day Trends

Historically, bear markets have only lasted 1.4 years, with some choppiness and a few rallies in between. This includes the nearly 3 year bear market at the start of the Great Depression, which skews the average and has not been repeated since. Bearish sentiment already took hold in the markets in early 2022, and we are well past 1.4 years of bear market dominance since then. 2023 is showing signs of being a bull year so far, and the matter of a recession in the near future has changed from a question of when the recession will come, to a question of if the recession will come. Since funds hedging against growth and innovation may only see gains in a bear market triggered by a recession or other macro trends that worsen market sentiment, the current positive trends appear quite foreboding for such funds for the medium to long term.

If the positive near-term trends we are seeing now prove durable and lasting, then in accordance with the business cycle, a years-long bull market bolstered by a growing economy will set the stage for business as usual, i.e. growth for large firms and disruptive innovators. Beyond the near term, however, one should anticipate such growth at some point this decade regardless, due to two longstanding historical trends: first, predictable and increasing levels of profitability and growth for mid- and large-cap businesses; and second, greater adoption over time of disruptive products and services offered by innovative companies like those in the ARK Invest funds, which will trigger growth for them as well.

Thus, in short (pun intended), the likely continuation of innovation and disruption will negatively impact the prospects of SARK and other innovation hedges as disruptive stocks rise, while the likely upward trajectory of economic progress and the corporate profitability that follows will negatively impact the prospects of HDGE and other general stock market hedges as mid- and large cap stocks rise.

SARK’s and HDGE’s Underperformance

Now to briefly look at each fund, starting with HDGE. HDGE has been trending downward essentially since its inception in 2011, when it shorted the S&P 500 near the end of the Great Recession and at the beginning of the next business cycle and bull-market. Its share price at inception was about 10x its current price, with the decline being so severe that the shares underwent a 1:10 reverse split in 2021; this while the fund’s assets have tended to lose value as well. Meanwhile, the S&P has risen over 200% since HDGE’s inception.

Turning to SARK, which is structured inversely against ARKK, the fund is currently trading higher than its inception date in late 2021, but it is very early days for the fund, and a multi-year analysis of its performance isn’t possible. Yet even in its banner year of 2022, SARK underperformed compared to expectations, demonstrating that even good short-term performance centered on betting against disruptive-but-frothy growth stocks may not pan out as expected.

To illustrate what I mean here, let’s look at SARK’s and ARKK’s 2022 performance. SARK first kicked off at around $30 per share and peaked at around $70 in late 2022, meaning that SARK, at its 2022 peak, rose by over 110%. Meanwhile, ARKK in late 2021 was priced at around $95 per share, and bottomed out at about $30 by late 2022, for a decline of almost 69%.

As an inverse/shorting ETF, one would expect SARK to rise to much more than double its value, since ARKK lost much more than half of its value, yet this was not the case. Even in the best case scenario for SARK, it underperformed expectations. Doubling one’s money on this investment is a solid feat, no doubt about it, but this was underwhelming even when it worked, and in the long term, it is not sustainable. Indeed, SARK has already given up much of its gains, with its price falling to about $45 at time of writing, and its assets’ value falling as well. One should expect continuing declines from HDGE and SARK in the long term, as their underlying benchmarks outperform them.

Implications for Similar Funds

Over time, other funds that similarly bet against larger corporations and innovative companies will also underperform the companies, funds, and indexes they are meant to hedge against. There are several funds like this, shorting or inversely correlated against bellwethers of corporate/economic growth and technological innovation, including the ProShares UltraPro Short QQQ ETF ( SQQQ ), the Direxion Daily S&P 500 Bear 3X Shares ( SPXS ), and the ProShares UltraPro Short Dow 30 ETF ( SDOW ). I will not mention them all here, but generally in the long term, as is the case for SARK and HDGE, so it will be for all such funds betting against innovation and growth – consistent underperformance during the dominant bull market years, with brief periods of decent performance during fleeting bear markets.

For long-term performance, then, it would be better to own stocks of innovative firms and funds tracking the major indexes. The Dow and S&P 500, in particular, have been tried-and-true indexes to follow in order to grow one’s portfolio for decades, with each index returning more than an order of magnitude of growth since just the 1980s, never mind the growth from decades prior. As such, long-term investments in ETFs hedging against them are very poor bets, in my view.

Thesis Risks

Long-Term Risk

The main risk to the thesis I see is that stocks for disruptive companies and companies across the major indexes crash so badly that the losses are unequivocally deep and devastating, and that the resulting market collapse is followed by a prolonged period of slow growth in stocks and the economy reminiscent of Japan’s Lost Decade(s).

I see this possibility as exceedingly unlikely in the US stock markets, due to the US’s large economy, sustained economic growth, fairly high regulatory standards for screening companies and listing stocks on public exchanges, and the presence of very business-friendly economic and regulatory conditions that seem to foster the growth of reliably high-value and innovative firms while weeding out bad actors, deceptive business practices, and corruption in the business realm.

To be sure, efforts to promote transparency, regulation, and anti-corruption initiatives are far from perfect, but the US has so far struck a decent balance between encouraging the growth of huge, regulated, legitimate businesses on public stock exchanges while ensuring stock markets remain favorable for the various stakeholders involved. This, combined with the strength of the US economy, will propel US stock markets and companies to make sustained gains.

Short-Term Risk

Another risk to the thesis, more centered on the short term, surrounds the present market conditions . According to this article by Michael A. Gayed, CFA, we may now be in the downward phase of a “melt-up” in the stock markets, which, in his view, could ultimately conclude in a steep march downward for stocks that erases many of the gains made after 2019. This risk is actually rather plausible, especially in light of stock market weakness in recent weeks.

While October has usually been a positive month for stocks, time will tell whether recent weakness last month was an isolated anomaly in the historical trends, or was evidence of a fundamental correction on the horizon, perhaps prompted by the reversal of 15 years of abnormally favorable monetary conditions. If the former, it matters little; if the latter, it would imply that we are either in bear market territory now, or we are headed back. In that case, the present trends brewing are much more negative than I gave them credit for earlier in this article.

Conclusion

While present trends offer great uncertainty about how large cap stocks and growth stocks will fare in the short term, historical trends offer strong evidence of long term upside. Therefore, even if worse comes to worst regarding the short-term risk of a correction or worse, my overarching thesis remains intact – the long-term benefits of investing in line with innovation and progress are more substantial than the benefits of hedging against it. The market crashes/corrections in the 1980s, the popping of the Dot Com bubble in the early 2000s, and the market fallout of the Great Financial Crisis and the Great Recession presented similar short-term risks, but overall, progress and innovation continued apace, and investors who weathered the storm and focused on the long term profited handsomely.

In sum, to paraphrase a famous minister, the arc of history is long, but it bends toward progress. Don’t bet against it, especially for the long term.

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