ARKK - TARK ETF: The Upside Can Be Huge But Know How To Play It

2023-04-19 10:45:44 ET

Summary

• AXS 2X Innovation ETF is an aggressive approach to betting on an already risky exchange-traded fund that invests in disruptive technologies.
• But there is a case to be made for owning shares. It involves trying to catch a bullish inflection point while protecting against big losses.
• Thoroughly research the risks associated with leveraged funds before committing any capital.

Cathie Wood's ARK Innovation ETF ( ARKK ) is a volatile fund (annualized standard deviation of 34%, more than double that of the S&P 500) that has largely disappointed any investor who has jumped on board in the last 24 months. So, why bother with an investment vehicle like AXS 2X Innovation ETF ( TARK ), which effectively leverages the daily performance of ARKK by a factor of two?

Generally speaking, leveraging an already volatile underlying asset can be a terrible idea beyond what one may potentially gain over a day or two out of sheer luck (more on the risks at the end of this article). But I also see the case for a speculative bet on TARK at its current, depressed levels - provided that the bet is limited in size and is sufficiently protected against sizable losses.

What is TARK?

Before moving on, let's take a closer look at the basics of this leveraged ETF. As suggested above, TARK has the stated goal of attempting to "achieve double the return of the ARK Innovation ETF for a single day, not for any other period." In that regard, TARK has done well. The following chart plots TARK's vs. double ARKK's daily returns and displays an r-squared of nearly one.

TARK charges a management fee of 0.95% per year that is in addition to any other expense that the underlying asset may carry. The exchange-traded fund ("ETF") is liquid and trades an average daily volume of 384,000 shares, the equivalent of $22.8 million exchanging hands during each trading session, on average.

The case for owning TARK

It is very reasonable to assume that TARK should only be day-traded and not held for much longer than one or two trading sessions. This would be consistent with TARK's stated goal of delivering twice the daily (not monthly or annual) return in ARKK. If this is the case, my contribution to this conversation ends here, as I have no opinion about the performance of either ETF over the next 24-48 hours.

But take a look at the following chart, which is in log scale to help better visualize the performance of two hypothetical buy-and-hold portfolios initially valued at $1,000 each. Because TARK has only been around since 2022, I back-tested how the leveraged ETF would have performed since ARKK's inception year of 2014 by manually leveraging ARKK's daily returns by a factor of two (orange line below). The blue line represents a plain investment in ARKK since its inception.

One thing should be obvious at first glance. A daily leveraged strategy tends to perform very well, and probably much better than many would expect, when the underlying asset is on the rise. The reverse is true: a daily leverage strategy performs terribly when the underlying asset is tanking and, as a consequence, volatility is higher than usual.

A speculative bet may be hugely successful, therefore, if it is placed near the inflection point where the underlying asset recovers from a sharp selloff. Back to the chart above: the ARKK x2 play would have returned a mind-blowing 1,516% in the ten or so months between the bottom of the COVID-19 bear and early February 2021 vs. "only" 338% gains in ARKK. We are looking at nearly five times the longer-term returns in ARKK when the ETF was on fire.

At this point, we could have a debate about whether ARKK is now at or near a potential bottom from which it should recover in the next months. I can see both sides of the argument, including the bullish thesis that (1) investing in innovation should yield market-beating results over the long haul, and (2) the worst of the interest rate increases is probably behind us, which should be good news for growth-biased strategies.

But here's where fundamental elements lose some of their importance vis-à-vis technical factors. More specifically: if the goal is to ride a potential uptrend while trying to stay away from downtrends, a simple moving-average approach might do the trick.

Of course, past performance is not indicative of future results. But still, back-tests are useful to understand the possibilities. If I were to own ARKK x2 since inception only when this "synthetic TARK" fund traded above its 200-day moving average while selling my shares when it dipped below the trend, this would have been the outcome (orange line below):

Trend-following would not have done too much to beat the performance of ARKK itself during periods of peace and quiet (think 2014 to 2019). But it would have been very effective at riding the updraft (think March 2020 to February 2021 as the best example) while hard-stopping losses beyond a given threshold (think 2021 and 2022).

To quantify the performance of the ARKK x2 (200 MA) strategy depicted above since 2014, the following are some of the key metrics on risk and return:

• Annualized gains of 26% : nearly three times higher than ARKK's
• Annual volatility of 43% : ten percentage points higher than ARKK's
• Max. drawdown of - 58% : 23 percentage points better than ARKK's.

Size the trade accordingly

In summary, I think that TARK could be a good fund to own, even well beyond a trading session or two, if the following conditions are met:

1. The investor is sophisticated enough to fully understand the risks;
2. The investor believes that ARKK may be at or approaching an inflection point from which it can recover from this 24-month-long bearish hangover;
3. A system for stopping the losses before they become too large, which could be a simple moving-average approach, is put in place.

I would add one final criterion to the list above. Because holding a leveraged ETF that tracks an already volatile underlying asset can be so risky, I would be very careful sizing the bet. At the risk of oversimplifying things, I would only buy TARK shares with money that I can afford to lose completely.

Each investor will have their own levels of risk tolerance and appetite, so it is hard to be prescriptive about what is reasonable. But I find it plausible for a growth investor with a long-term horizon to allocate 10% of the total portfolio to more aggressive or speculative plays - think new technologies, new consumer trends, crypto, etc. Within this bucket, the TARK trade could represent somewhere between one-tenth to one-fifth of the "YOLO allocation."

An important word on leveraged ETF risks

Leveraged instruments have particular risks that other investment vehicles do not. Most notably, volatility drag (also known as volatility tax, beta slippage, value erosion, decay, and other names) makes a long-term investment in LETFs more exposed to losses than many realize.

This is the case because these funds reset daily, as per their stated methodology, making it nearly impossible for the long-term performance of the ETF to be equal to twice that of the underlying asset - returns can be worse in the case of high volatility in the market.

FINRA and the SEC elaborate further on these risks, and I suggest readers go through their warnings thoroughly before committing any capital.

For further details see: