BMO ARK Innovation Fund ETF Series - ARKK

General Market Commentary

Broad-based global equity indexes¹ appreciated in the second quarter as NVIDIA’s guidance for the second quarter shocked on the high side of expectations, thanks to provocative proofs of concepts from artificial intelligence (AI) generally and ChatGPT specifically. Increased demand for AI hardware is pointing toward a significant acceleration in software revenue growth. As companies develop AI-powered products and services, ARK estimates that software may generate up to $8 of revenue for every dollar spent on AI hardware by 2030. In what could be ​“winner take most” opportunities, we believe companies with large pools of proprietary data and broad-based distribution should be best positioned to capitalize on AI use cases and reap the potentially dramatic productivity gains associated with generative AI.

Economic data was not as clear-cut. While the labor market seemed resilient, a number of leading indicators were warning of recession.

• With a strong correlation to Gross Domestic Product (GDP), the US Leading Economic Index (LEI) has dropped for 14 consecutive months and now is down 7.9% year-over-year.² In 2022, GDP declined for two consecutive quarters, a technical recession. During the last two quarters, Gross Domestic Income (GDI) — which should equal GDP over time — has declined sequentially. The divergence in growth between GDP and GDI is begging the question about future revisions: will GDI be revised up or GDP down. Our view is the latter.
• Based on monthly surveys from the Federal Reserve District Banks of Dallas, New York, Philadelphia, Richmond, and Kansas, manufacturing activity is contracting at an accelerated rate. Corroborating this evidence, new orders in the national Purchasing Managers’ Index are declining.
• According to the Senior Loan Officer Opinion Survey (SLOOS), the willingness of banks to lend is plummeting, often a leading indicator of recession. Borrowing and lending play pivotal roles during economic expansions. The demand for commercial and industrial (C&I) loans is consistent with previous recession levels, and the Bank of America Fund Manager Survey suggests that commercial real estate could be the epicenter of the next financial crisis.

• US consumer sentiment³ remains at levels last seen during the Global Financial Crisis in 2008-2009 and back-to-back recessions with double-digit inflation and interest rates during the early 1980s. Meanwhile, the personal saving rate has collapsed from 9.3% pre-COVID to 4.6%⁴ which, when coupled with historically low consumer sentiment, is pointing toward weakness in consumption growth. Adding to those concerns, the third largest category of non-housing debt, credit card balances have reached a record high level at ~$1 trillion.⁵ Because interest rates on credit cards nearly doubled to 20-21% during the past ten years, the burden of credit card debt has intensified. Additionally, student loan payments are slated to resume this October, further pressuring consumer purchasing power.
• In recent months, PIMCO and Brookfield have defaulted on commercial property mortgages across major US cities, a trend exacerbated by the combination of rapid interest rate increases and the lower occupancy rates associated with the shift to remote work environments. Recent trends have hit San Francisco particularly hard, the value of one commercial use building dropping from $300 million to $60 million, or 80%, in four years.⁶ Moreover, two of San Francisco’s largest hotels are vacating the city. 

Recent economic data and comments from the US Federal Reserve (Fed) appear to have tempered investors’ previous expectations of interest rate declines. Now, interest rate futures are pricing in a slowdown or recession and one or two more rate hikes before interest rates start to decline. Should an economic slowdown evolve into a hard landing, the slope of interest rate declines could steepen.

The Federal Funds Target Rate has surged 21-fold in the last year, a faster pace than all previous tightening cycles — including the one in 1980-1981 that crushed inflation--creating significant strains at regional banking and in commercial real estate. Bank deposits have dropped 4.2% year-over-year, the largest decline since 1948.⁷ We believe additional rate hikes will exacerbate this fragile situation. 

While the Fed is determined to squelch inflation by increasing interest rates, the bond market has been signaling that it could be making a major mistake. Since March 2021, the yield curve⁸ has flattened by 265 basis points, inverting from +159 to -106 basis points,⁹ the worst inversion since the early 1980s when the Fed was fighting entrenched double-digit inflation. This dynamic suggests that both real growth and inflation could surprise on the low side of expectations. In ARK’s view, the Fed is making decisions based on lagging indicators — employment and headline inflation — and ignoring leading indicators that are telegraphing recession and/​or price deflation.

The Federal Reserve began increasing interest rates when the year-over-year Consumer Price Index (CPI) — a lagging economic indicator — reached 8.5% on a year-over-year basis in March 2022. Shortly thereafter, an inflationary surge influenced by geopolitical pressures and inventory hoarding peaked at 9.1% year-over-year. Since then, CPI inflation has dropped to 3.0%,¹⁰ thanks to various deflationary forces – – good, bad, and cyclical. Tesla’s CEO Elon Musk¹¹ and DoubleLine’s CEO Jeff Gundlach¹² have echoed our concerns about the risk of deflation.

Innovation is a potential source of good deflation, as learning curves can cut costs and increase productivity. Yet, we believe many companies have catered to short-term-oriented, risk-averse shareholders, satisfying their demands for profits/​dividends ​“now”. On balance, they have leveraged their balance sheets to buy back stock, bolster earnings, and increase dividends. In so doing, many have curtailed investments and could be ill-prepared for the potential disintermediation associated with disruptive innovation. Saddled with aging products and services, they could be forced to cut prices to clear unwanted inventories and service debt, causing bad deflation.

If we are correct in our assessment that growth, inflation, or both will surprise on the low side of expectations, scarce double-digit growth opportunities should be rewarded accordingly. The adoption of new technologies typically accelerates during tumultuous times as concerned businesses and consumers change their behavior much more rapidly than otherwise would be the case. As a result, stocks of innovation-oriented companies have historically performed better and emerge as new market leaders toward the end of a bear market. We believe the coronavirus crisis and Russia’s invasion of Ukraine have transformed the world significantly and permanently, suggesting that many innovation-driven strategies and stocks could be productive holdings during the next five to ten years.

In our view, the wall of worry bodes well for equities in the innovation space. The strongest bull markets climb walls of worry, a fact that those making comparisons to the tech and telecom bubble seem to forget. No wall of worry existed or tested the equity market in 1999. This time around, the wall of worry has scaled to enormous heights.

Fund Commentary

Among the top contributors were Tesla (TSLA) and Exact Sciences (EXAS). Tesla shares rallied following several events. During its annual shareholder meeting, Tesla announced that co-founder J.B. Straubel would join the Board of Directors. Then, Tesla competitors General Motors, Ford, and Volvo announced that they will adopt the Tesla charging connector and join the Tesla Supercharger network in the coming years. Furthermore, SAE International, the automotive industry body that sets and reviews engineering standards, announced that it would standardize Tesla’s North American Charging Standard connector. Lastly, Tesla reaffirmed its promise to deliver the first Cybertrucks this year. Shares of Exact Sciences contributed to performance after the company surpassed revenue and earnings expectations for the first quarter and guided to positive free cash flow during 2023. In addition, Exact’s next-generation Cologuard screening test for colon cancer demonstrated better specificity and sensitivity than Exact’s existing product, so it will seek FDA approval of the new test by the end of this year

Among the top detractors from performance were Pager Duty (PD) and Zoom Video Communications (ZM). Shares of PagerDuty traded down after the company reported earnings with higher-than-expected revenues for the first quarter but lower than expected full-year guidance based on the persistent macro headwinds that are extending sales cycles and limiting seat expansion. In our view, demand for automated incident support software will increase as artificial intelligence (AI) enhances the efficiency and productivity of software developers. Thanks to its proprietary data and early adoption of AI, we believe PagerDuty is positioned to be a prime beneficiary of this trend. Shares of Zoom declined after an analyst from Citibank focused on increased competition in the enterprise communications space and negative data points suggesting slower growth generally. We maintain conviction in Zoom’s potential to share most of the enterprise communications platform space with Microsoft.

Portfolio Construction

Weights are subject to change and are as of June 30, 2023.

Portfolio Manager Bio

Catherine « Cathie » D. Wood

Cathie registered ARK Investment Management LLC (“ARK”) as an investment adviser with the U.S. Securities and Exchange Commission in January 2014. With over 40 years of experience identifying and investing in innovation, Cathie founded ARK to focus solely on disruptive innovation while adding new dimensions to research. Through an open approach that cuts across sectors, market capitalizations, and geographies, Cathie believes that ARK can identify large-scale investment opportunities in the public markets resulting from technological innovations centered around DNA sequencing, robotics, artificial intelligence, energy storage, and blockchain technology. As Chief Investment Officer (“CIO”) and Portfolio Manager, Cathie led the development of ARK’s philosophy and investment approach and has ultimate responsibility for investment decisions.

Prior to ARK, Cathie spent twelve years at AllianceBernstein as CIO of Global Thematic Strategies where she managed over $5 billion. Cathie joined Alliance Capital from Tupelo Capital Management, a hedge fund she cofounded, which in 2000, managed approximately $800 million in global thematic strategies. Prior to her tenure at Tupelo Capital, she worked for 18 years with Jennison Associates LLC as Chief Economist, Equity Research Analyst, Portfolio Manager and Director. She started her career in Los Angeles, California at The Capital Group as an Assistant Economist. Cathie received her Bachelor of Science, summa cum laude, in Finance and Economics from the University of Southern California in 1981.

In 2018, Cathie launched the Duddy Innovation Center of Excellence at her alma mater, Notre Dame Academy in Los Angeles. The institute offers a challenging educational experience for young women eager to stretch their learning beyond the boundaries of traditional acquisition of knowledge, while influencing a new way of thinking and learning throughout the campus.

¹ As measured by the S&P 500 and MSCI World. 

² The Conference Board. Data as of May 31, 2023. 

³ As of June 30, 2023, measured by the University of Michigan. 

⁴ Federal Reserve Economic Data. Saving rate was 9.3% as of February 1, 2020, and 4.6% as of May 1, 2023. 

⁵ Federal Reserve Economic Data as of February 1, 2023. 

⁶ Wall Street Journal. Published April 27, 2023. 

⁷ Federal Reserve Economic Data as of June 21, 2023. 

⁸ As measured by the difference between yields on the 10-year Treasury bond and the 2-year Treasury note. 

⁹ An inversion means the long-term Treasury yield is lower than the short-term Treasury yield. The yield difference was +159 basis points on March 29, 2021, and -106 basis points on June 30, 2023. One basis point is equal to 1/100 of a percentage point, or 0.01%.

¹⁰ US Bureau of Labor Statistics. Data as of June 30, 2023. 

¹¹ https://twitter.com/elonmusk/status/1569948349549379585

¹² https://www.cnbc.com/2022/09/13/gundlach-says-buy-long-term-treasuries-as-deflation-is-the-bigger-threat-right-now.html