Is This the End of Cathie Wood? | ARKK Fund Collapsing

One of the new stars in the investment world over the past few years has been Kathy Wood. She has had a successful and established career on Wall Street but really became a household name relatively recently with the company she founded, Arkhanvest, and its popular ETFs. Frankly, this attention was deserved, and her fund was making investors a ton of money with its strong performance.

Her flagship ARK Innovation ETF returned a staggering 87% in 2017, 36% in 2019, and an eye-popping 157 percent in 2020. However, the fund is off to a terrible start this year, down nearly 24% already this year and off roughly 50% since its all-time peak back in early 2021. In this video, we are going to go over why Kathy Wood and her fund are struggling, why hedge funds are betting hundreds of millions of dollars against her, and if this really is the end of Kathy Wood's rise.

Kathy Wood really started to become a household name in 2018 when the still relatively unknown fund manager went on national television and said that she believed that Tesla's stock price would hit four thousand dollars by the year 2023. This statement came at a time when the electric car maker was facing tremendous issues in terms of production and quality control. It was also in the middle of a liquidity crunch that made many believe that the Elon Musk-led company might go bankrupt soon. At the time, Tesla was trading at $300 per share, and many people thought it was overvalued even at that price. To put it bluntly, many respected investors thought that she was just crazy.

However, her prediction did come true two years earlier than was predicted. In January 2021, Tesla closed at eight hundred and sixteen dollars, or four thousand eighty dollars on a split-adjusted basis. Since this call, Wood has been one of the most popular fund managers. Her investment company funds innovative projects like self-driving cars and genomics and also places heavy bets on companies working in sectors like alternative energy, space exploration, and digital currencies.

So why is Kathy Wood's portfolio full of high-growth, mostly unprofitable stocks struggling as of late? Three words: rising interest rates. It's no secret that inflation has been high. In fact, the most recent inflation numbers that were released showed inflation at seven percent in the United States, the highest inflation rate since 1982. This means that inflation is at its highest in almost 40 years. In order to combat this high inflation, the U.S. Federal Reserve has said that they will start raising interest rates, and rising interest rates are not good news for high-growth tech stocks.

Let me show you why. In order to understand the impact interest rate changes have on tech stocks, we first have to understand that the value of any financial asset, including a stock, is the amount of cash that the asset will generate over its lifetime, discounted back at an appropriate interest rate. Let me show you what I mean by having me walk you through an example.

In this super-simplified example, let's say we have a company that produces two dollars in cash flow in year one and is able to grow that two dollars in cash flow by an additional two dollars each year for 10 years. This means that in year 10, the company will have generated $20 in cash flow. Additionally, in order to find the value of this company, we also need to estimate how much we can sell this company for at the end of the 10-year period. This is referred to in finance as the terminal value.

In this example, let's say we can sell this company for five times its year ten cash flow of twenty dollars. So this means we will receive an additional one hundred dollars in cash flow at the end of year ten by selling the company. Now that we have our cash flows, we now have to discount those cash flows back using an interest rate. Now, this part is super important as it explains a lot of what is happening in the stock market right now.

Let's say the rate we use to discount the cash flows is five percent. This means the value of the stock is one hundred and forty dollars. But let's say interest rates decrease to three percent. This actually increases the value of the stock to 164 dollars, even though the cash flows that the company produced remained the same. The stock became worth more simply because the interest rate decreased.

Now take a guess what happens when I do the opposite and increase the interest rate. You guessed it! The value of the stock becomes less. If I increase the interest rate to seven percent, the stock is now worth 120. If I increase the interest rate to 10%, the stock is now worth 97. This is such an important concept in investing, and by understanding this, you will have a better idea of what is happening in the stock market.

So this still leaves a question: why is the possibility of higher interest rates hurting the kind of stocks Kathy Wood owns in her portfolio more than the average stock? This is because the kind of stocks that are in her portfolio are much more sensitive to interest rates. Let me show you what I mean.

In this example, we have two stocks: a high-growth stock and a traditional value stock. Notice the difference in their cash flows. The high-growth stock is currently unprofitable and, as a result, is actually generating negative cash flow. This is typical for a lot of the names in Kathy Wood's portfolio. The companies she owns are growing so quickly that they are unprofitable and losing money.

So for simplicity purposes, let's say the growth stock loses four dollars in year one. The loss gets smaller each year until the company breaks even at the end of year five and then quickly grows cash flow by two dollars a year until year ten. Because it is growing so quickly, its terminal value multiple is high—let's say eight times—meaning at the end of year ten, the terminal value of the company is 80, calculated by taking the year ten cash flow of 10 and multiplying it by 8.

On the other hand, let's say we have a value stock that is currently generating cash but is growing much slower compared to the high-growth tech company. In this example, let's say this company generates five dollars in year one but is only able to grow that yearly cash flow by 25 cents each year. At the end of year 10, the company is generating 7.25 cents in cash flow. As a result of its lower growth, the terminal multiple is lower for this company. Let's say it's only four times. This means the terminal value of this company is 29.

Something interesting to point out is that even though the value company started out making much more money than the growth company, at the end of year 10, the growth company has an annual cash flow of ten dollars while the value company is only at seven dollars and 25 cents. Now, and this part is super important, let's see how varying interest rates affect the value of these companies.

Let's start with discounting these cash flows at one percent. This means the high-growth tech company would be worth ninety dollars a share while the value stock would only be worth eighty-four dollars. With a one percent discount rate, the high-growth tech stock would be worth around six dollars more. Now if we raise that interest rate up to two percent, the high-growth tech stock is worth 81 dollars and the value stock is worth 78 dollars. Now the high-growth stock is only worth three dollars more.

At a three percent interest rate, both the high-growth tech stock and the value stock are both worth 73 dollars. Now, bringing the interest rate up to four percent, the high-growth tech stock is now worth 66 dollars while the value stock is worth 69 dollars. Now the value stock is actually worth three dollars more than the high-growth tech stock. Finally, let's increase the discount rate up a few percentage points to eight percent. In this case, the high-growth stock is worth forty-four dollars while the value stock is worth fifty-three dollars—nine dollars more than the high-growth stock.

This is obviously a super simple example, but it demonstrates the power of how differing interest rates can affect the value of different stocks. It also should serve as a high-level explanation of why Kathy Wood's portfolio is getting hit so hard right now. Notice how nothing changed regarding the underlying performance of the business in terms of how much cash each business generated. However, the value of each stock varied wildly just by adjusting the discount rate up and down.

The reason interest rates affect these two stocks differently has to do with the timing of the cash flows. Notice how with the value stock, a larger portion of the cash rate will be generating in the beginning years, while with the high-growth stock, the majority of the cash flow is in later years and especially in year ten, with a very large terminal value. The higher the discount rate, the more important it is to get the cash flow earlier. This is because the longer it takes to receive the cash flow, the more impact an increased discount rate will have on it.

Wood's portfolio is full of these types of high-growth names. Take a look at our top 10 holdings in the ARK Innovation ETF: Tesla, Zoom, Teledoc, Roku, Coinbase, Unity Software, Spotify, Exact Sciences, Twilio, and Block, previously known as the company Square before its rebranding. It's also important to note that these top ten positions in the fund make up over 54% of the entire fund. Compared to most actively managed funds, this is extremely concentrated.

Typically, the more concentrated a portfolio is, the more the value of the portfolio can fluctuate. This is a concept referred to as volatility. Since each name makes up a relatively large portion of the entire portfolio, poor performance in some of the largest positions can have a sizeable impact on the performance of the entire fund. This is what is happening with Kathy Wood's portfolio, as some of the biggest positions in the portfolio have struggled as of late.

Of her top 10 largest positions, not a single one has had a positive return so far this year, and some have frankly been hit pretty hard to start out the year. For example, Wood's second-largest position, video conference company Zoom, is down 13% this year. Teledoc, the fund's third-largest position, is down 13% so far this year. Consumer electronics company Roku, the fund's fourth-largest position, is down nearly 27% so far this year. Unity Software, the fund's sixth-largest position, is down nearly 18% this year. Her ninth-largest position in the fund, Twilio, is down over 18% to start the year. Block, the mobile payment company formerly known as Square, her 10th-largest position, is down over 17% this year.

However, some very smart investors believe that there is still more pain in store for the ARK Innovation fund. Remember how in the introduction to this video, I talked about how hedge funds are betting hundreds of millions of dollars against Kathy Wood? While hedge funds are shorting, aka betting that the ARK Innovation fund will continue to fall at an all-time high rate, nearly seven percent of the ARK Innovation ETF shares outstanding are currently being shorted by investors. To put that in perspective, just 2.8 percent of Tesla shares are currently being shorted.

Traditionally, a heavily shorted stock... hedge funds are doing this because this is a way to short a portfolio of high-growth, unprofitable tech stocks without exposing themselves to the risk of shorting any one stock in particular. Shorting individual stocks can be extremely risky, as demonstrated by the GameStop fiasco not too long ago. This is because when you short a stock, you're betting it is going down. If the stock you are short instead rises in value, you lose money. In theory, you can lose an infinite amount of money if the stock you are short increases in price dramatically, like what happened with the meme stocks.

As a result, some hedge funds have taken to shorting Kathy Wood's entire portfolio to avoid the risk of any one stock shooting up but still benefiting if high-growth tech stocks continue to fall due to rising interest rates.

So there you have it. Make sure to like and subscribe to the Investor Center because it is my goal to make you a better investor. As always, thank you for watching, and I'm looking forward to speaking to you again soon.