3 lessons I learned from a high-risk ETF

Earlier this year, my friend asked me whether Cathie Wood's ARK funds were a gamble.

ARK’s flagship investment strategy, ARK Innovation ETF (ARKK), posted a mind-boggling 152% annual return in 2020. Such eye-popping returns caught my friend’s attention. Meanwhile, others questioned whether these returns were sustainable and if there was any room left on the ARK.

So far this year, the skepticism has been justified. ARKK has lost 14.11% year to date as of November 29, 2021, more than 33 percentage points below its Morningstar Category benchmark, the Morningstar Mid Growth Index. The fund’s poor performance has landed it in the bottom 1% of its category.

Investors have begun to abandon ARK Innovation amid its underperformance. Fund flows into ARKK were positive, but showing signs of slowing, in the first quarter of 2021. Since then, $1.9 billion in assets have left the fund as of the end of October.

Morningstar analysts have dug into ARK Innovation’s portfolio and questioned whether the tail wags the dog. But when I asked myself ARKK is right for me, the following three reasons made me hesitant to buy shares.

One: I’m already overweight in growth stocks

If I’m adding a new fund to my portfolio, one of the first things I do is check my current asset allocation. There are few ways to do this, but one way is to use Morningstar’s instant x-ray tool.

Around 40% of my portfolio is in growth-oriented stocks, 21% in value-oriented stocks and 39% in a blend of growth and value stocks. The growth number seems high compared with my value exposure, but it’s not too different compared with a broadly diversified US stock index fund.

Here’s what my portfolio looks like compared with Vanguard Total Stock Market ETF (VTI), which receives a Morningstar Analyst Rating of Gold.

Now let’s look at the style box-breakdown of ARKK--if I were considering buying shares.

It has a nearly 70% stake in growth companies, which is the opposite of what I need in my portfolio. If anything, I should consider a value-oriented fund to start chipping away at my growth tilt.

Two: I don’t have a stomach for volatility

Christine Benz recently explained that risk, not volatility, is the real enemy to accomplishing financial goals. She defines risk as the chance of not meeting financial goals or having to change them because an investor came up short when saving.

From this lens, I’m not too worried about risk--I’m luckily on track to save for my financial goals. But that doesn’t mean I’m not bothered by volatility, which Benz defines as price fluctuations in an investment, portfolio, or market segment over the course of one day, month, or year.

ARKK tends to be volatile. “The fund’s relative results tend to be boom or bust,” analyst Robby Greengold explains. “Its relatively concentrated and benchmark-agnostic portfolio means investors should have a stomach for volatility.”

I don’t have a stomach for volatility--and that’s okay. Not everyone does.

Three: I love forget-about-them investments

ARKK belongs in my "too hard" pile. This is a phrase borrowed from Charlie Munger, one of Warren Buffet’s closest business partners. It generally refers to investments that aren’t worth the effort to understand or require more patience than an investor can handle.

Given my sensitivity to volatility, it’s easier to describe what’s not in my "too hard" pile than every investment that’s in it. Low-cost, broad-market index funds usually align with my investment preferences.

My final thoughts

It turns out my friend has most of his assets in an S&P 500 fund. Assuming he owns one that is low-cost, that’s sound. But my friend wanted to use ARK funds as mad money, a small portion of his portfolio dedicated to more speculative, potentially high-returning investments.

Though ARKK isn’t for me, there are far wackier ways he could invest his mad money.