QQQ Stock – Invesco QQQ Trust, Series 1 (QQQ) Stock price, News
After posting a scorching hot 150% return in 2020, ARK Innovation ETF (ARKK), the flagship fund of Catherine Wood (Trades, Portfolio)’s ARK Investment Management, experienced a staggering deluge of capital inflows from investors and allocators looking to juice up their gains. The exchange-traded fund has delivered annualized gains of 35% since its launch in 2014. The Nasdaq 100 Index, by comparison, delivered 21% annualized return over the same period. The attraction for yield-hungry investors is obvious.
However, while ARK Innovation’s headline performance may appear attractive at first glance, a look below the surface reveals that its outsized gains have come at the price of outsized volatility.
A dangerous attraction
Sustained market-beating returns are notoriously difficult to deliver for even the most capable investors. That difficulty has, as I have discussed previously, resulted in a significant migration of investor and allocator capital away from active trading strategies and into index funds. Thus, actively managed funds that consistently outperform benchmark indexes always attract attention. Such has been the case with ARK Innovation.
The ETF appears to be head and shoulders above the Nasdaq 100, when simply looking at their comparative returns. However, a closer examination reveals that while it posted a superior return, ARK Innovation was also radically more volatile – 73% more, to be exact. Consequently, it appears less fair to compare the ETF’s performance to that of the index.
In order to get a better picture of comparative performance, we need to determine risk-adjusted, not just absolute, return.
How Sharpe than a serpent’s tooth
One way of determining risk-adjusted comparative returns is to use the Sharpe ratio, as analyst Mark Hulbert did on March 27, when he compared ARK Innovation to the Invesco QQQ Trust (QQQ), an index fund that tracks the Nasdaq 100:
“[The Sharpe Ratio] is the ratio of a fund’s average returns to the standard deviation of those returns. The Sharpe Ratio of ARK Innovation’s monthly returns since 2014 is almost precisely the same as the QQQ’s…If you had been willing to incur the ARK Innovation’s increased volatility, you could have made just as much by leveraging an investment in the QQQ. That is, you would have made just as much by increasing your portfolio allocation to QQQ, or by buying it on sufficient margin.”
We can use the Sharpe ratio to derive a more accurate “apples-to-apples” comparison between two securities, since it adjusts for relative volatility of returns. In the case of ARK versus the Nasdaq 100, there appears to be no inherent advantage to the high-flying ETF. Simply expanding exposure or levering up a position in a fund tracking the Nasdaq 100 would produce the same outcome. In other words, ARK Innovation’s outsized performance may be illusory.
For Fama, French and fortune
The Sharpe ratio is just one tool for assessing risk-adjusted performance and it alone cannot justify the definitive dismissal of ARK’s seemingly exceptional performance. We must test it against other metrics if we hope to reach a confident conclusion, such as the Fama-French model, which compares mutual fund and ETF performance against a basket of indexes covering a range of strategies and weightings. Hulbert ran the numbers again using this widely regarded metric:
“The answer for ARK Innovation is “no” — an overweight allocation to a small-cap growth fund would have produced the same overall return since November 2014.”
Once again, we see that closer analysis of ARK’s performance only serves to throw its supposedly market-beating returns ever further into doubt. Of course, this does not mean that the ETF’s outsized headline returns have been the result of pure luck. However, there is also no affirmative evidence that true market-beating skill was involved.
Liquidity liquidity everywhere, but not a stock to sink
We have been comparing ARK Innovation to the Nasdaq 100, as has become popular among analysts and market commentators. However, the comparison is questionable for more than their divergent volatilities. Perhaps of even greater concern is its comparative illiquidity. As I have discussed previously, the ETF has a number of outsized positions in relatively small stocks, a trend that has only intensified in recent weeks. Given what we have learned already, namely that ARK’s returns are not outsized on a risk-adjusted basis, the ETF starts to look less attractive than the highly liquid Nasdaq 100, as investor and commentator Roger Barris pointed out on March 26:
“Unlike the NASDAQ 100, which is composed of extremely liquid stocks, AARK has heavy concentrations in illiquid stocks. The chart above shows that investors in ARKK are not being paid for taking on this dramatically higher liquidity risk. That’s not smart.”
The same risk-adjusted return for a far less liquid investment is rarely a winning proposition. ARK Innovation’s continued dabbling with extremely illiquid securities, despite it having caused considerable trouble during last month’s pullback, seems to make it an unfavorable alternative to other strategies that could mirror the same performance while remaining highly liquid.
Though ARK Innovation has gotten off to a rocky start in 2021, with a negative 2.4% return year to date, the ETF’s track record has continued to attract investor attention – and dollars. Few investors seem to be concerned about more than the headline return, at least not yet. Should another market reversal shake investor confidence, as it did in March, ARK’s extreme illiquidity could again prove dangerous.
In sum, I see ARK Innovation as an interesting novelty to watch, but not a security worth owning. There are better ways to achieve the same return profile while maintaining substantially greater liquidity. When things go wrong, illiquidity can be seriously bad news.
Disclosure: No positions.
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About the author:
John Engle is president of Almington Capital Merchant Bankers and chief investment officer of the Cannabis Capital Group. John specializes in value and special situation strategies. He holds a bachelor’s degree in economics from Trinity College Dublin, a diploma in finance from the London School of Economics and an M((BA)) from the University of Oxford.