Webcast #17: Invest at Your Own Risk (6 minutes)

Last week, fund rating agency Morningstar downgraded Cathie Wood’s ARK Innovation ETF. After posting exceptional returns in 2020, the fund has since fallen from grace as disruptive technology growth stocks have declined sharply in value.

Morningstar attributed its downgrade to the fund’s elevated risk profile.

Full disclosure: we’ve never bought or sold a unit of the ARK Innovation ETF and wouldn’t be interested in doing so now. Its investment style does not fit into our conservative mandate. We prefer an entirely different universe of companies and look for quite different metrics when buying or selling stocks than the attributes which appeal to Cathie Wood. However, the reasons for the downgrade caught our attention.

First, Morningstar suggests that Wood has “saddled the portfolio with greater risk by slashing its number of stocks to 35 from 60 less than a year ago.” In the case of the ARK Innovation ETF, which invests in similar companies (disruptive technology) with highly correlated stock returns, owning 60 or 35 stocks will not in our opinion change the direction of the fund’s returns. It would have been more productive to criticize the high correlation between the stocks (either 60 or 35) within the fund itself.

SPWM spreads its investments across multiple sectors in order to reduce the correlation of asset prices in client portfolios. For example, Utilities and Consumer Stables are defensive names you are happy to own in market downturns while Materials and Technology tend to accompany more growth and consequently, volatility. We would never own 65 stocks and believe that even 35 is too much. We prefer 20-25 depending on the client’s circumstances and believe that figure achieves diversification when spread across multiple sectors.

Second, Morningstar argues that Wood’s “reliance on her instincts to construct the portfolio is a liability.” The alternative, which presumably eliminates instincts, would involve investing based upon a mathematical algorithm. This method eliminates the very judgment that accompanies the experiences, opinions, and wisdom that a good Portfolio Manager must possess. Speaking to students in the 2000s, Warren Buffett commented on the principals of Long-Term Capital Management, which required a government bailout in the 1990s, who employed quantitative models to manage money.

“Yet, the downside, particularly managing other people’s money, is not only losing all your money, but it’s disgrace, humiliation, and facing friends whose money you have lost. I just can’t imagine an equation that makes sense for. Yet 16 guys with very high IQs, who were very decent people, entered into that game. … History does not tell you the probability of future financial things happening. They had a great reliance on mathematics. They felt that the beta of the stock told you something about the risk of the stock. It doesn’t tell you a damn thing about the risk of the stock in my view.”

Warren Buffet

In addition to utilizing our judgment to make investments based on all information at our disposal, our clients own stocks across multiple sectors to achieve diversification.