Here's How Cathie Wood (Almost) Completely Missed the Boat on Artificial Intelligence (AI) -- and the Simplest Way You Can Avoid Making the Same Mistake

Cathie Wood's ARK Invest rose to prominence during the 2020 and 2021 boom in unprofitable growth stocks and was helped along by a high concentration in Tesla (TSLA +0.69%) -- which soared a staggering 743% in 2020.

But over the last five years, all the major Ark exchange-traded funds (ETFs) have underperformed the S&P 500 and the Nasdaq Composite. Here's how Ark Invest lost its edge over the market, why the funds have largely missed the boat on artificial intelligence (AI), and how you can avoid making the same mistake.

Image source: Getty Images.

ARK's strategy

Each year, ARK publishes a 100-plus page research report on its best and biggest ideas and the companies it invests in to capitalize on those trends. What made ARK gain popular attention is that it assigned heavy weightings to relatively small companies and excluded most megacap names (except Tesla).

ARK has six actively managed ETFs. I excluded the ARK Space Exploration & Innovation ETF (ARKX 0.45%) in this article because the fund was launched just a few years ago and only has $236 million in net assets.

• ARK Innovation ETF (ARKK +0.00%)
• ARK Next Generation Internet ETF (ARKW +2.23%)
• ARK Fintech Innovation ETF (ARKF +1.64%)
• ARK Autonomous Technology & Robotics ETF (ARKQ +0.34%)
• ARK Genomic Revolution ETF (ARKG 0.87%)

Here's a look at the top 10 holdings in each of the other five actively managed ETFs.

Data source: ARK Invest.

There are several duplicated holdings across multiple funds. For example, UiPath is in four out of the five funds, and Tesla, Robinhood, Block, and Coinbase are in three out of the five. There's a lot of overlap between the ARK Innovation ETF, Next Generation Internet ETF, and the Fintech Innovation ETF.

What led to ARK's underperformance is a high concentration in a few fairly niche companies across its ETFs. Many of these stocks have cooled off since their run-up in 2020 and 2021 and are down big from those highs.

The Invesco QQQ Trust (QQQ +1.91%) mirrors the performance of the Nasdaq-100 -- which includes the 100 largest non-financial companies in the Nasdaq Composite. Given its high-growth nature, we'll use it as a benchmark instead of the S&P 500 to see how these funds are doing.

Year to date, the Invesco QQQ is up 12%, and the best-performing ARK ETF, the Next Generation Internet ETF, is only up 2%. The disparity gets even worse when we go out over a three-year period, with the Invesco QQQ up over 40% compared to 28% or more declines across all five major ARK ETFs. Even if we look back over the last five years, which includes the 2020 run-up in a lot of ARK's top holdings, all five ETFs are still trailing the Invesco QQQ, indicating the severity of the sell-off in many of ARK's favorite companies compared to the gains of top growth stocks.

QQQ Total Return Level data by YCharts.

The dangers of being underweight market leaders

ARK's underperformance is highlighted by two major misses over the last few years. The first and most important is that megacap stocks, not small-cap stocks, have been leading the market to new heights across most sectors. ARK's active ETFs don't focus on megacap stocks, so they have missed out on this trend. The megacap stock ARK is a big believer in, which, again, is Tesla, is down around 24% since the start of 2021.

The second and more glaring miss is that ARK did not have enough exposure to AI, which has been led by megacap growth companies like Nvidia and other chip stocks, Microsoft, Alphabet, Amazon, Meta Platforms, and others. It has some small positions in AI-focused companies and even some big tech names, but not enough to move the needle of an ETF.

Index funds and sector-based ETFs are market-cap-weighted to include high exposure to these massive behemoths. But ARK's allocation is based on its best ideas, not market cap. And unfortunately, these ideas haven't been very good over the medium term. They could still work out, but for now, the flaws of ARK's strategy are on full display.

Although there's no perfect formula for ensuring you have "enough" megacap growth stocks in your portfolio, there are certain thresholds to be aware of. The tech sector makes up 29.2% of the S&P 500. The "Magnificient Seven" -- which includes Microsoft, Apple, Nvidia, Amazon, Alphabet, Meta Platforms, and Tesla -- make up 31.4% of the S&P 500, but there are plenty of megacap growth stocks outside of these names that carry high weights in the index. It's also worth mentioning that Amazon and Tesla are in the consumer discretionary sector, not tech. And Alphabet and Meta Platforms are in the communications sector.

All told, I'd say that any portfolio that was less than 40% to 50% in megacap growth probably underperformed the major indices in recent years. If you are mostly invested in companies outside of megacap growth and have the risk tolerance to approach the space but don't know where to start, a good idea may be the Vanguard Mega Cap Growth ETF (MGK +1.68%).

That ETF has crushed the Nasdaq Composite and S&P 500 in recent years, has a ton of exposure to tech and the consumer discretionary sector, and has 55% of its weighting in Microsoft, Apple, Nvidia, Alphabet, Amazon, and Meta Platforms. It also has just a 0.07% annual fee -- or $7 for every $10,000 invested.

Due to its high concentration in a few names and themes, the fund will likely be extremely volatile based on the top companies' earnings results and investor sentiment. But it's a great way to plug a hole in your portfolio if you're underweight some of the market's largest and most important companies.

Use ETFs to your advantage

In the stock market, anything can go up in the short term, which often happens for the wrong reasons. But over the long term, fundamentals win out.

ARK Invest gained popularity because its strategy perfectly aligned with what was hot at the moment and because it stood by Tesla when there was widespread doubt that it would ever scale to reach the mass market. ARK deserves a lot of credit for making that bold call on Tesla, but that doesn't mean it's worth replicating every move by Cathie Wood and her team.

As an individual, you can choose which funds or famous investors to look up to while also understanding their weaknesses and the context of their holdings. The joy of investing in individual stocks comes from understanding a company well and believing in it long term. And if there's a certain sector or theme you want to invest in, but you don't have any high-conviction ideas, then an ETF is a good way to fill a void while also achieving diversification.