2023-12-14 05:03:05 ET
Summary
- During 2023, growth stocks are once again outperforming value stocks by a very wide margin, but ARK Innovation ETF is lagging behind.
- The term premium is the only game in town when it comes to ARKK's expected returns.
- For anyone interested in investing in high growth names, there are better alternatives to ARKK.
After a disastrous 2022, the current year is on track to be yet another strong year for growth stocks, with the gap between growth and value once again widening to extreme levels.
Although interest rates are up during the year, credit spreads and volatility have both trended down, thus improving financial conditions and aiding high risk assets.
This set-up couldn't have been more favourable for ARK Innovation ETF (ARKK), which holds stocks with very high expected growth rates and duration.
Unfortunately, however, investors who have been holding the ETF for a longer period of time, 2023 was hardly enough to make a difference. ARKK is still way-below its 2020-2021 highs, and the fund has now delivered a total return of 19% over a period of 5-years. This equates to an annual return of a mere 3.6% for bearing exceptionally high volatility during a period of time that has been the most favourable for growth stocks.
Justifying such a dramatic underperformance for bearing much higher risk is nearly impossible, and more importantly is no guarantee that anyone buying at 2023 lows is doing so at bargain levels.
As we see on the graph above, the Vanguard Growth Index Fund ETF Shares (VUG) has done a far better job than ARKK during the past 5-year period by delivering a total return of 121%, which translates to more than 17% on an annual basis.
Back in July of this year, I already warned of the risks of extrapolating VUG's recent performance into the future. Not only does the same apply for ARKK, but the ETF's heavy exposure to the term premium is a risk that is often ignored on the assumption that innovation within the holding companies is all that matters.
It's All About The Term Premium
The sharp variations of ARKK both on the upside as well on the downside in recent years should have been major warning sign that innovation hardly matters for shareholder returns.
Instead, it is financial conditions that affect the pricing of high duration assets and more specifically the term premium component within the overall equity risk premium, which has collapsed following the unprecedented monetary response to the pandemic in 2020.
In addition to Treasury yields, the size of the Federal Reserve's balance sheet is often used as a key metric for overall liquidity within the markets and a key driver of the aforementioned term premium. By taking this approach, one could easily assume that since the balance sheet has shrunk over the past year then financial conditions have become somewhat tighter over the period.
In reality, however, what matters more in our case is not the total demand of bonds that the graph above gives an indication of, but rather the maturity profile of bonds supplied to the market. By changing the mix between notes and bonds, the U.S. Treasury could affect different segments of the yield curve and thus the term premium.
That is why the quarterly refunding announcements by the Treasury are having profound impact on long-duration assets, such as the stocks held by the ARKK.
The extract above is from the latest quarterly refunding announcement on November 1st, when the share of long-term bonds relative to short-duration notes has fallen dramatically (note that the Treasury provides the plan for the next 3-month period on each announcement date)
prepared by the author, using data from U.S. Department of the Treasury
With less supply of long-term bonds in the market, their price has increased and yields have gone down following the announcement. This is exactly what we have observed since 1st of November to this date.
Consequently, to the falling long-term yields and the term premium, risk assets have experienced a significant tailwind and that is why we also see the NASDAQ Composite going from 12,600 to 13,533 in a matter of weeks.
By holding assets with extremely high duration, the ARKK ETF has been an enormous beneficiary from this trend and as a result returned 37% since first of November.
On the graph below, we could also see the dramatic increase in ARKK daily volumes since the quarterly refunding announcement on the 1st of November.
This higher volume was in anticipation of yields falling and risk-assets significantly outperforming in response to the falling term premium.
With all that in mind, the next quarterly refunding announcement at the end of January 2024 will be a very important date for ARKK investors. In particular, investors should look at the plan for issuance of long-dated bonds over the next 3-month period. If the downward trend continues, then ARKK would most likely enjoy yet another 3-month period of strong performance. Should the opposite is about to happen, however, the ETF is likely to suffer.
Low Quality Businesses
The risk of the term premium increasing in 2024 is a major risk for holder of ARKK going forward. On top of that, the low quality business models of the top holdings of the fund create an asymmetric risk-reward profile.
As we saw above, the accommodative financial conditions in 2023 were hardly enough to move the needle for ARKK when it comes to reaching the 2020-2021 highs once more. At the same time, the higher quality holdings for the VUG have resulted in the ETF once again trading near its all-time highs.
The ARKK ETF is also characterized with extreme concentration risk, with the Top 10 holdings having more than 63% weight within the fund.
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When comparing the Top 10 holdings of VUG and ARKK we could see that the average beta of the former stands at 1.2 while that of the latter is significantly higher at 1.7.
What this means is that the ARKK holdings have significantly higher market risk and nonetheless are still underperforming the VUG holdings.
The situation is the opposite when we take a closer look at gross margins, which are a good proxy for the strength of the business models as they are less affected by the realized economies of scale that come with larger size and give a good indication of the pricing premium that each business achieves.
As we see on the graph below, the Top 10 holdings of the VUG have an average gross margin of 62% or more than twice as high as the average gross margin ARKK's Top 10 Holdings of only 25%.
Some of the top ARKK's holdings are still loss making, in spite of their large size. Companies, such as Coinbase Global (COIN) and Block ( SQ ) have market capitalizations of $33bn and $42bn respectively, which leaves little room for more economies of scale to allow them to achieve high and sustainable GAAP profitability.
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Block, for example, still struggles with pivoting the business towards profitability at a time of strong consumer spending and other macroeconomic tailwinds.
Conclusion
The future return profile of ARK Innovation ETF is far less attractive than its innovation-driven narrative is. In spite of all the talk about disruptive technology, at the end of the day it is the term premium that's in the driver's seat of future returns. On top of that, the lower business model quality of the fund's top holdings is a major risk that significantly increases downside risk, especially during marker downturns.
For further details see:
ARKK: Forget About Innovation And Focus On What The U.S. Treasury Does