It's been a few brutal months for growth-oriented technology investors like myself. Many tech stocks have enjoyed astronomical gains over the past year in spite of — and in some cases, thanks to — the COVID-19 pandemic, so a pullback isn't entirely unexpected. Still, drawdowns of this magnitude can be difficult to experience both financially and emotionally. There's also been talk of rising interest rates alongside recent concerns about inflation that have contributed to souring investor sentiment.
For many of these reasons, I recently shorted Cathie Wood's flagship ETF, Ark Innovation (NYSEMKT: ARKK). Here's why.
Hedging against the sell-off
In many ways, Ark Innovation has become the poster child for speculative, high-growth tech stocks. As such, the actively managed ETF has been especially vulnerable to the recent pullback. As of Friday's close, Ark Innovation is approximately 35% off of its highs set in February.
The fund enjoyed incredible outperformance in 2020 as many of its holdings put up blockbuster returns during the pandemic due to a variety of factors. Technology companies were instrumental in helping people and businesses adapt to a world where a deadly virus forced everyone to work remotely, and enterprise organizations had to accelerate digital transformations. At the same time, there has been hope for electric vehicle (EV) stocks, as adoption is rising and the Biden administration is enacting supportive policies.
To be clear, I'm optimistic about the long-term prospects of many of Ark Innovation's core holdings. In fact, I own many of the fund's top 10 holdings outright. Specifically, I hold Tesla, Roku, Shopify, Spotify, and Twilio, and plan to continue doing so.
The reason why I'm shorting Ark Innovation is to put a hedge in place for potential downside protection if growth stocks continue to sell off. While maintaining long positions in many of the same holdings, shorting the ETF can potentially generate gains to offset short-term declines in the individual positions, thereby providing some defense for my overall portfolio. I only regret that I didn't put this hedging strategy in place sooner.
I considered alternative strategies, such as buying a bearish put spread on the tech-heavy Nasdaq Composite (NASDAQINDEX: ^IXIC), but hedging with options can be more volatile due to all of the factors (the Greeks) that impact options pricing. Time decay (negative theta) can be costly, and ultimately I determined that shorting Ark Innovation outright would be more cost-effective, even after factoring in borrowing fees. Furthermore, Ark Innovation is more concentrated in the specific stocks that are especially weak right now, while the Nasdaq Composite is more diversified.
Tech's long-term prospects remain strong
For what it's worth, Wood remains optimistic on the outlook for technology stocks. In a recent interview with CNBC, the growth investor dismissed concerns around the pullback. “From our point of view — five-year time horizon — nothing has changed except the price,” Wood told the outlet.
Ark Innovation continues to buy tech stocks, as shown by its daily trade disclosures. If anything, the pullback might result in greater annual returns going forward. At the February peak, Wood said that Ark was expecting a compound annual growth rate (CAGR) of around 15%. As Ark continues to buy the dip, the fund is now raising its estimates to a CAGR of 25% to 30%.
Tech stocks, as measured by the Nasdaq Composite, have a long historical record of outperforming the other two major indexes. That includes greater volatility at times, but patient investors have little to be worried about. A little hedging in the short term can also help smooth out the swings.
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Evan Niu, CFA owns shares of Roku, Shopify, Spotify Technology, Tesla, and Twilio and is short shares of ARK Innovation ETF. The Motley Fool owns shares of and recommends Roku, Shopify, Spotify Technology, Tesla, and Twilio. The Motley Fool recommends the following options: long January 2023 $1,140 calls on Shopify and short January 2023 $1,160 calls on Shopify. The Motley Fool has a disclosure policy.