Forget ARKK ETF: invest in technology with these 2 high yields
Co-produced by Austin Rogers for High Yield Investor
There’s more than one way to skin a cat, and there’s more than one way for investors to get exposure to high-growth, innovative technology companies.
In this article we have Take a look at two different ways to gain exposure to this higher risk, higher reward segment of the economy:
- An exchange-traded fund that’s innovative but largely unprofitable Publicity Stocks represented by Cathie Woods ARK Innovation ETF (ARKK).
- Business Development Companies (“BDCs”) specializing in providing high-yield, short-term loans to, and selective equity investments in, innovative but mostly unprofitable companies Private Companies represented by Hercules Capital (HTGC) and Trinity Capital (TRIN).
ARKK is an active ETF with fairly high turnover and an expense ratio of 0.75%, which falls somewhere between the expenses of passively and actively managed funds.
The ETF typically holds between 35 and 55 stocks with a median market cap of around $5 billion, but there’s a fairly wide range of company sizes within the portfolio. Although all holdings could be considered “innovation” or “high technology” companies, they operate in a number of areas/industries:
- The “genomic revolution” and other DNA-based biotechnology
- automation and robotics
- Energy storage and battery technology
- Artificial intelligence
- Fintech (financial technology)
ARKK is a long-only equity-only ETF focused on innovative (and typically new-to-public) publicly traded companies. Sometimes these companies are profitable and sometimes they aren’t, but a large portion of them remain in cash burn mode as they continue to invest in growth.
On the other hand, HTGC and TRIN are BDCs specializing in venture debt – specialty loans with a typical 2-4 year maturity for fast-growing private companies that are not yet profitable but are backed by venture capital funds. In addition, they often invest collectively, taking equity or warrants in their portfolio companies to earn high returns from the few that turn out to be big winners.
These are largely the same types of companies that would be owned by the ARKK ETF, except they are still private and have not yet completed an IPO. The IPO is one of the potential liquidity events that can result in the ultimate return of capital (and ideally return on invested capital) for companies like HTGC and TRIN.
In some cases, ARKK can even provide liquidity by buying shares in technology company IPOs. As such, it’s important to recognize that ARKK invests in generally the same types of companies as HTGC and TRIN, only those that are further along in their early growth process toward profitability.
Here are some examples of TRIN’s portfolio investments, and the company also had equity exposures to many, if not most of these:
And here are some examples from HTGC’s portfolio, particularly holdings in stocks and warrants:
From the stock investor’s perspective, it’s important to note the difference in the primary sources of income for each investment.
- ARKK does not pay a dividend, and its only The source of income is capital appreciation from rising share prices of the underlying investments.
- HTGC and TRIN both return most of their distributable cash flow to shareholders as dividends, offering high yields in the high single digits or low double digits. Returns come primarily from dividends, but can also come from capital appreciation.
Let’s compare ARKK to HTGC and TRIN to see why investors might choose BDCs over Cathie Wood’s popular ETF.
Stability vs Popularity
ARKK has approximately $76 billion in assets under management, nearly 30 times HTGC’s total assets and nearly 80 times TRIN’s total assets. On the other hand, ARKK is a fund holding dozens of companies, while HTGC and TRIN are individual companies.
Despite this, ARKK’s median market cap of $5 billion is several times larger than HTGC’s market cap of $1.7 billion or TRIN’s market cap of around $550 million.
ARKK is clearly the more popular investment. Indeed, it became a financial phenomenon during the pandemic, as its cluster of high-tech stocks capitalized on the stay-at-home trend and its main spokesperson, Cathie Wood, became a much-interviewed oracle in the financial media.
And yet, the massive surge in stock picking successes and capital inflows that ARKK experienced in the 10-11 months following the onset of the pandemic proved short-lived as ARKK has fully rolled back its steps to pre-pandemic levels – below, actually . Year-to-date, ARKK appears to have flattened out after losing over 50%.
Compare this to the price action of HTGC and TRIN, which have also fallen in value but not nearly to the same extent as ARKK.
If we zoom out further, we find that ARKK has strong has lagged behind HTGC and TRIN on a price basis alone since TRIN debuted in the public markets in January 2021.
But the price obviously doesn’t tell the whole story, as the main source of income for HTGC and TRIN is dividends. When we factor in dividends to arrive at a total return comparison, we find that the performance differential between the BDCs and ARKK has become even more extreme since TRIN’s IPO.
If we omit TRIN to go further back with a head-to-head comparison of ARKK and HTGC over the past five years, we find that even after ARKK’s huge gains during the pandemic and HTGC’s price decline by 25 % has outperformed over the past several months.
However, once the bear market ends, should investors expect ARKK to resume its massive outperformance?
There are some reasons to believe that this might be the case. ARKK could see a strong recovery from the current bear market due to Cathie Wood’s outspoken defense of its strategy and investors’ fear of missing out on another rally.
On the other hand, the massive surge ARKK experienced during the pandemic should also be viewed as a one-time event that is unlikely to happen again. ARKK has benefited from stay-at-home mandates and social distancing, as well as pandemic-era stimulus funds that people have been playing with in the stock market. This fad is over. And we probably won’t have another once-in-a-century pandemic for a while.
In addition, when interest rates rise, investors attach more importance to it currently Profits and unanticipated profits that will be far in the future, as is the case with ARKK’s holdings.
On the other hand, both HTGC and TRIN benefit directly from rising interest rates since a majority of their portfolio loans are floating rate. As of Q1 2022, approximately 60% of TRIN’s loans are floating rate:
At HTGC, the percentage of adjustable rate loans reaches almost 95%:
In addition, both BDCs have interest rate floors on their loans, minimizing the downside of falling interest rates. In general, these loans are the best of both worlds, as the downsides to variable rates are limited while the benefits are potentially huge.
The greatest risk for young growth companies
For all young growth companies that are still in cash burn mode while investing to grow their business, there is a constant need to raise more and more capital. This becomes a problem when the capital markets dry up and money becomes tighter.
Without the ability to raise capital at reasonable rates, startup growth companies can easily run into trouble.
Is this a bigger problem for venture capital? lender like HTGC and TRIN or equity investors like ARKK?
I would argue that this is a bigger problem for the stock investor side, as the inability to raise capital at reasonable prices can seriously impair a company’s ability to grow at a young age, which should then lead to poor stock price performance. This then leads to poor price performance for ARKK.
On the other hand, venture capitalists like HTGC and TRIN are in a stronger position as venture-backed companies prioritize meeting their existing obligations to avoid defaults. Avoiding default or bankruptcy is almost always preferable to any other option.
Of course, when capital markets dry up, exiting stocks or warrants may have to wait or yield lower than hoped-for returns. However, this is a relatively small portion of the total return generated by the venture debt business model practiced by HTGC and TRIN.
Cathie Wood is undoubtedly a smart person with a keen eye for innovative technology. Their research department is among the best at not only identifying technological trends, but also capturing the imagination and interest of investors. It’s not surprising that her confident, unflinching, and prolific marketing of ARK Invest has borne fruit over the past few years.
But it seems unlikely that their flagship ETF, ARKK, will see another massive surge emerging from the current malaise like it has seen during the pandemic. COVID-19 has created an extremely favorable environment for ARKK to skyrocket, and these unique circumstances are unlikely to be repeated anytime soon.
However, investors have an opportunity to invest in substantially similar (often the same) companies that ARKK holds while enjoying greater stability, lower downside risk, some upside opportunities through equity and warrant exposure to portfolio companies, and quarterly cash returns in the form of dividends.
It feels great to invest in America’s innovation machinery, and at High Yield Investor we strive to deliver strong returns while participating in human progress. But there’s more than one way to do that. Investors looking for high yields and relatively low volatility would do well to take an in-depth look at HTGC and TRIN.