Dear subscriber,
215%.
That’s the return on Catherine Wood’s ARKK Innovation ETF from the outset of 2020 to its peak.
Financial advisors can’t stop binging on this buzzworthy ETF.
But they do so at their own peril!
Here’s why that matters and what you can do about it.
You see, many don’t appreciate the hidden dangers embedded in this ETF.
And one is staring them right in the face.
I’m talking about rising interest rates.
We talked about this in Monday’s Wall Street Connected Newsletter.
Now, we want to expand on this critical topic so understand why interest rates matter so much.
Now vs. the future
Any investor worth their salt understands that future profits aren’t worth as much as ones today.
To determine the value of a future cash flow, investors use what’s known as a discount rate.
This rate fluctuates in line with interest rates.
The higher interest rates go, the less future cash flows are worth to you today.
Lower interest rates mean that futures cash flows are worth more today.
Here’s a quick example.
Imagine I offered you $100 today or $10 every year for the next 12 years.
How do I compare the $100 to the $10 each year for 12 years?
We use a ‘discount rate.’
Let’s say my discount rate is 10%. That means every year in the future is worth 10% less than the prior year.
Over the 12 years, your cash flows would be worth $61.45 given a 10% interest rate.
However, if I dropped that rate down to 1%, those same cash flows are worth $94.71.
The formula for discounting cash flows requires a calculator or excel in most cases.
If the interest rate were 0%, those cash flows would be worth exactly $120.
Why, you ask? Because there isn’t any alternative ‘risk-free*’ investment (IE Treasury Bonds) that I could choose instead.
*We call treasury bonds risk-free, but it’s only an approximation as there is always some risk. However, if the U.S. government fails to pay its bond obligations, we will be facing bigger problems!
Not Noah’s ARKK
To be clear, ARKK’s ETF is only down 25% from its highs.
What the TrackstarIQ search data tells us is the ETF remains popular among institutional advisors.
At the same time, not all the underlying holdings see the same interest.
This implies advisors aren’t doing their due diligence on these companies.
Here’s a quick look a the top 10 holdings for the ARKK fund:
| Weight | Company | Ticker | Market Price | Shares Held | Market Value |
| 9.99% | TESLA INC | TSLA | $563.00 | 3,572,503 | $2,011,319,189.00 |
| 6.23% | SQUARE INC | SQ | $201.87 | 6,206,854 | $1,252,977,616.98 |
| 5.86% | ROKU INC | ROKU | $327.19 | 3,607,730 | $1,180,413,178.70 |
| 5.64% | TELADOC HEALTH INC | TDOC | $176.65 | 6,422,130 | $1,134,469,264.50 |
| 3.42% | BAIDU INC | BIDU | $232.68 | 2,956,887 | $688,008,467.16 |
| 3.34% | ZILLOW GROUP INC | Z | $124.66 | 5,391,580 | $672,114,362.80 |
| 3.32% | SPOTIFY TECHNOLOGY | SPOT | $258.33 | 2,583,741 | $667,457,812.53 |
| 3.27% | SHOPIFY INC | SHOP | $1,072.43 | 612,951 | $657,347,040.93 |
| 3.20% | CRISPR THERAPEUTICS AG | CRSP | $113.62 | 5,671,565 | $644,403,215.30 |
| 2.99% | ZOOM VIDEO COMMUNICATIONS | ZM | $310.93 | 1,937,984 | $602,577,365.12 |
Some of these companies turn a profit.
But are they a value?
I don’t know about you, but Tesla trading at a price-to-earnings (P/E) ratio of 879x doesn’t strike me as a discount.
So, when markets value these companies, they look at their future earnings and discount them to the present.
That’s great when interest rates remain low.
But even small increases in rates can chop off these stocks at the knees.
Finding those ‘Pink Diamonds’
As investors, how do we separate the good from the bad?
A great place to start is looking at whether the company currently turns a profit. Teledoc (TDOC) might be a great idea at the right time. But, they need revenue growth and margin improvement…not the easiest thing in the world.
Warren Buffet loves to invest in companies he understands. Such a simple piece of advice works wonders when you try to determine the value of a business.
Or you can simply hedge your portfolio with stocks like financials (XLF) and regional banks (KRE) that benefit from rising rates.
What you choose should make sense for your goals and portfolio. Don’t worry about everyone else. They’re in the same boat.
