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ARK Innovation and XLB - Factorial analysis

Updated: Dec 4, 2023


Ark Innovation is Cathie Wood’s main actively managed ETF that, in the fund’s words, «seeks long-term growth of capital» and «seeks to achieve this investment objective by investing under normal circumstances primarily (at least 65% of its assets) in domestic and foreign equity securities of companies that are relevant to ARK's investment theme of disruptive innovation. ARK defines "disruptive innovation" as the introduction of a technologically enabled new product or service that potentially changes the way the world works».

Even though disruptive innovation might seem fancy and abstract at first, it is quite straightforward to grasp where the ETF’s focus lies: growth stocks. Indeed, 80.9% of the fund relies on companies that have between medium and large market capitalization, of which the great majority belong to the high-tech and healthcare sectors – 70%, as can be read from the chart aside. This portfolio composition allowed Cathie Wood’s fund to vastly outperform the S&P 500 and MSCI World Index during the pandemics’ worst hardships.

Nonetheless, all those praiseworthy gains have entirely vanished in this extremely tough 2022 so far for the ETF. If you have invested $10’000 in December 2021, a simple indexing strategy would have been much better for your portfolio; in fact, those $10’000 invested in the S&P 500 would have given you back $7’600, with a consequent loss of 24%, in contrast with ARK Innovation’s performance, which would have shrunk your initial investment in merely disappointing $3’800, amounting to a total loss of $3’800. This is really a tough nut to crack for Cathie Wood, who is facing major outflows from her fund since her fund’s assets under management have collapsed from a peak of $28 billion in early 2021 to only $8 billion today.

But how did this happen? Which are the reasons behind this poor performance? The nature of ARK’s picks and the current macroeconomic hardships due to inflation may provide a clear explanation.

Value vs Growth Stocks

Before proceeding, it is key to tackle an elementary yet relevant distinction within the financial markets: value and growth stocks. These two different categories resemble opposite styles of investing which might, at first glance, seem at odds with each other. However, it would be misleading to state that investors must choose to be either pure value or growth investors, since more and more both types are combined in diversified portfolios.

Value stocks are generally represented by all those companies that are believed to be undervalued. In other words, well-established firms with solid financials that are traded below their real worth, consequently traded at discounted P/E, book value, or cash flow ratios.

On the other hand, growth stocks embody riskier investments. Indeed, it is about a bet that investors are willing to make on companies with high multiples and which may pay low or no dividends, though considered to be able to deliver better-than-average growth and gain an edge on their market – as a result of their reinvestments of retained earnings into the company to expand.

As aforementioned, it is not puzzling to fathom that Cathie Wood’s bet is entirely on growth stocks, and this is key information.

Growth Stocks vs Inflation

Over the last decade, the battle between the two categories has been very one sided, with growth almost always on the winning side. Until 30 years ago banks and oil companies were the big giants of the market, but since then FAANG stocks and other big high-tech companies – such as Tesla – have been gaining the upper hand.

Inflation though is telling a different story; indeed, since mid-2021 value stocks have conquered the podium again, whereas the slowdown in demand for digital companies has been cutting growth stocks’ legs. In addition, rising interest rates and a very likely recession in sight do not bail out this type of stock. But which are the reasons that explain the poor performance of growth stocks, as is happening to ARK Innovation, in this specific macroeconomic context?

The stock market and economic growth are two essential players that must be present in the answer. For most of the small and medium cap growth companies, the stock market acts as a lifeblood. In fact, a great number of these firms operates with free cash flows that are almost null, if not negative, which makes them heavily reliant on capital raised by investors, who are willing to put their money in companies that are still at their embryonic stage and that are expected to gain much higher profits in the future. When interest rates are low, it is easier to raise capital and chase growth. Yet, when the trend is reversed, inflation hits and central banks are forced to raise them, then the story completely changes.

Markets are closely linked to investors’ expectations. It is straightforward to catch that the stock market suffers if investors are afraid or have pessimistic forecasts about the future of the economy. This is true for both value and growth stocks; when the markets go down, both types of companies are inevitably affected. Although, whereas solid and profitable companies are able to withstand and go through the storm, growth companies still need their lifeblood. Therefore, they should anyhow find a solution to raise capital, but there are a few that are harmful to the company, such as selling massively their own stocks – with a consequent profound devaluation – or financing through debt – which is extremely costly due to high interest rates. At the end of the story, whatever option is undertaken, growth stocks’ value comes to be utterly destroyed.

ARK Innovation: Opportunity or Disaster?

What is next for Ark Innovation? Are investors right and is it wise to run away or may it be an inviting opportunity to buy at a discount price?

It is impossible to give a certain answer to this question right now since the macroeconomic landscape is way too uncertain. If inflation suddenly drops and the economic direction improves, then a fund with high-multiples and market beta such as ARK Innovation would be an opportunity that should be grasped, since current prices are quite attractive. However, this scenario, to date, is quite unlikely; hence, it is compelling to understand how ARK Innovation’s picks will behave through this storm that is raging and if Cathie Wood will change strategy to rein in her fund’s losses and stem the resulting massive capital outflows.


The Materials Select Sector SPDR® Fund (XLB) seeks to provide exposure to companies belonging to the chemical, construction material, containers and packaging, metals and mining, and paper and forest products industries. This fund is built from the S&P 500 Composite, which is then divided into 11 Select Sector Indexes. It includes many different companies whose average market capitalization is around $33 billion. It is quite exposed to individual companies performance and market conditions, therefore its price could fluctuate more than expected. We can see that the chemicals sector has the largest weight on the fund, accounting for almost 69%, followed by metals, packaging and construction material. It is passively managed, meaning that there are no arbitrary changes in sector weights, it samples the existing index in terms of risk factors and other characteristics.

It is crucial when studying a fund to check if it is liquid enough to be traded quite frequently, and as we can see the 30-day median bid-ask spread is 0.01%, which is a great result, meaning that you can enter and exit your position quite easily, even the volume statistics support this result.

Moreover we can study if a fund is overpriced or underpriced, by looking at the premium discount to NAV, which measures if it is traded far from its net asset value (asset minus liabilities, divided by outstanding shares). In this case it is really close, without any warning signal. However from the graph below it is clear that the fund has suffered from a higher volatility during the last year, due to the high uncertainty in the markets.

By looking at the major performance indicators for the last 10 years we noticed that this fund has a higher Alpha and a lower Beta compared to the average fund in the same category. This shows that it has had an excessive return compared to the market, while keeping the Beta slightly above 1. Even volatility is lower than the average.

XLB: growth or value?

Based on data gathered by Morningstar, we should consider XLB as a blend fund, this means that it is not exposed uniquely to growth stocks nor to value stocks, this theory is supported also by its P/E ratio, which is slightly above 15. This is implicitly correct, since its aim is to sample the material index and it is not a “speculative” fund, whose main goal is to cover what are believed to be the most profitable companies. Usually SPDR funds are used to hedge the portfolio, the most common strategy is to short the fund or to buy put options. This is possible because these funds are traded like stocks.

This graph shows XLB price in blue and the S&P 500 in orange. As we can see both of them have really similar graphs. This happens because the basic materials sector is subject to the law of supply and demand in the same way as consumer goods and the global market are. In fact, they are closely interrelated. If the demand for consumer goods drops, the demand for the raw materials involved in their production also drops. The same happens for the housing market, since raw materials are usually finished in order to be used as construction materials, so any shift in housing demand has consequences on basic materials prices, look at the sudden drop of 2008.


In this paragraph we are going to run a factorial analysis, which seeks to explain the returns of a security or portfolio by breaking market movements of the underlying asset into its fundamental constituents, on the two ETFs previously mentioned, ARKK & XLB. In such an analysis we are going to use the six factors from the Fama-French-Carhart model, an asset pricing model that expands on the capital asset pricing model by adding size risk, value risk, profitability risk, investment risk and momentum risk factors to the market risk factor. Essentially we will attempt to explain historical returns of such securities by categorizing the overall market performance in 6 risk premiums representing compensation for risk undertaken by investors by taking exposure to the six factors.

  • Market (MKT): The return of the regional value-weighted market portfolio minus the U.S. one-month T-bill rate.

  • SMB (Small Minus Big): The difference between the return of a portfolio that holds small stocks (Small cap) and the return of a portfolio that holds big stocks (Large cap).

  • HML (High Minus Low): The difference between the return of a portfolio that holds value stocks (based on the B/M criteria) and a portfolio that holds low value stocks (based on B/M criteria).

  • RMW (Robust Minus Weak): The difference between the average returns on diversified portfolios of stocks with robust and weak profitability.

  • CMA (Conservative Minus Aggressive): The difference between the average returns on diversified portfolios of the stocks of low and high investment firms.

  • WML: This is the momentum factor (Winners Minus Losers). It is the difference between the return of a portfolio that holds the stocks that were Winners in the last 12 months and a portfolio of the stocks that were Losers the last 12 months.


ARKK is an actively managed fund that seeks long-term capital growth from companies globally involved with, or that benefit from, disruptive innovation.

The R-squared of ARKK is 0.803, this exhibit that the six factors explain the performance of the ETF with an accuracy of 80.3%; one of the reasons that led us to this value is the fact that ARKK has 33 holdings and the company's top 5 holdings make up 34% of its total portfolio.

The Mkt factor is 1.7091, which means that if the market increases (decreases) by 1%, ARKK will rise (drop) by 1.7%. We could have expected this value also before the analysis, since this ETF is allocated mostly in growth companies, as we can also see from SMB (small minus big) factor. This product has a negative loading about HML and RMW.

The table below shows the total real returns of various long/short equity strategies in inflationary, deflationary periods and times of price stability. In the final columns, we present the hit rate (proportion of inflationary periods with positive returns), and the heteroskedasticity-consistent t statistic that tests whether the returns in inflationary and non-inflationary times are different.

Smaller companies perform poorly in inflationary regimes. In real terms, the premium for being long small size and short large size is -4% a year in inflationary periods, compared to +1% in normal times.

The factor is positive in just two of the eight episodes. The costs of inflation will have some economies of scale benefit to them. The extra effort that companies have to make when the value of cash is more volatile. Value companies are more suited to reacting to these conditions, given that they are more likely to have the necessary infrastructure to make such adaptations seamlessly.

We think ARKK is full of overvalued assets, investing in ARKK means that we will be overexposed to growth stocks. Growth companies are often unprofitable and have speculative prospects, during a period of high inflation and an increase of interest rates will underperform the market.


XLB tracks a market-cap-weighted index of US basic materials companies.

From such analytical results we can observe that the only statistically significant factor is the Mkt-RF one, but from a market cap weighted index we could have predicted that SMB would have resulted as insignificant in the hypothetical explanation of the ETF market movements, given the fact that in this fund the company with the largest market cap will represent the largest weight in the index, meaning mega cap companies will impact the performance of the overall index more than a small cap company will. R-squared index is 81.8%, we have this value as a consequence of the chosen ETF. The fund includes only the materials components of the S&P 500, so it isn’t equally diversified as an ETF that replicates the market, also in the basket of stocks: the firsts 10 top holdings makeup 63% of its total portfolio.


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