Cathie Wood’s company, Ark Investment Management or Ark Invest, is one of the hottest money managers on Wall Street today. In the past year alone, assets under management have increased more than tenfold, rising from $ 3.1 billion to $ 34.5 billion as a combination of excellent performance and cash inflows have skyrocketed.
The company’s most popular exchange-traded fund is the Ark Innovation ETF (ticker: ARKK), which has returned 150% over the last year.
Wood’s other Ark ETFs have had similar impressive results. For example, at the time of this writing, the ARK Genomic Revolution ETF (ARKG) is up 160% over the past year.
In early February, Ark had amassed more than $ 50 billion in AUM as more than $ 11 billion in inflows fell into Woods Fund after a stellar 2020.
In short, Cathie Wood and Ark Invest are the envy of fund managers everywhere. For now.
However, there is a risk that investors who accumulate in Ark ETFs may not take them as seriously as they should.
The nature of the funds flows
Investors chase returns and pile up when the funds get “hot”.
And they predictably do the opposite when the funds hit a cold spell.
For what it’s worth, this is a problematic pattern for individual investors themselves who end up buying high and selling low. A 2007 paper on fund performance by Geoffrey Friesen and Travis Sapp published in the Journal of Banking and Finance found that equity fund investors underperformed the funds themselves by 1.56% annually between 1991 and 2004. That adds up, especially when it’s put together every year.
A Morningstar study for the Aughts from 2000 through late 2009 found a nearly identical tidbit: the average stock and bond fund returned 3.18%, while the average investor earned just 1.68% per year – 150 basis points less per year Year.
What does that mean? It just confirms that investors have a tendency to pursue returns, pile up at elevated levels, and sell out when things change.
It also means we can expect redemptions if Ark gets into a period of underperformance. And then things could get ugly.
Concentration / liquidity risk
Unlike mutual funds, ETFs are not required to keep cash on their books to protect themselves from the fall of investors selling or redeeming fund shares. Instead, through a process of creating and redeeming shares, Authorized Participants must essentially sell shares of the underlying securities when investors redeem their ETF shares.
The problem with Ark stems from the large number of holdings in which Ark holds a large percentage of outstanding shares. Of course, these tend to be smaller companies with lower daily trading volumes.
When investors start selling Ark ETFs, the underlying securities must be sold. As of February 13, there were 25 companies in which Ark Invest owned more than 10% of the outstanding shares.
One question that might arise here: does this mean the problem with Ark is liquidity or cash flows?
“I would say the two are very closely related. I would say that it is a potential illiquidity problem that is being recognized in many drains,” says Edwin Dorsey, author of The Bear Cave newsletter.
“When there are inflows, it doesn’t matter how liquid you are because you keep buying this stuff. It’s like a bank is undercapitalized but everyone keeps depositing money – there will never be a bank failure,” says Dorsey.
“So it’s a liquidity problem that comes to the fore when there are many sudden outflows,” he says.
Knowing Ark’s concentration issues here not only makes exiting positions problematic, it also makes its funds vulnerable to being run at the top by hedge funds that are selling or shorting some of these illiquid names, Dorsey says.
“When people start saying, ‘Oh, Ark is doing badly; retail investors are starting to cash out – let’s turn them upside down.’ Not only will you have Ark selling pressure hurting these illiquid stocks, you will have it all. These funds are short-circuiting these names, pushing them down and expecting Ark to do so next week, “he says.
It’s a feedback loop with the very real potential of connecting to yourself. If Ark has to sell large quantities of small businesses and flood the market with stocks, there won’t be a big price in the open market.
This of course affects the performance of the Ark ETFs themselves and makes further redemptions more likely if the well-known tendency of investors to sell in downturns is true.
Take that away
Ark certainly recognizes how focused its portfolio has become in certain names. On Friday, the fund family silently changed their prospectus to change their own rules for ETF portfolios. Ark ETFs can now invest more than 30% of their holdings in a single security and own more than 20% of a single company.
To put these (now abandoned) limits in context, many diversified mutual funds limit themselves to investing no more than 5% of assets in any one security and no more than 20% or 25% of assets in any single sector.
Ark’s decision to ditch these earlier concentration rules could deter the company from inevitably breaking its own rules if current trends continue, but it only exacerbates the problem lamented by Dorsey and others.
In either case, there is likely to be a period of underperformance soon – although this is not solely due to liquidity issues.
“I think the biggest risk for Cathie Wood and ARKK is the concentration of holdings,” said Robert Johnson, finance professor at Creighton University in Omaha, Nebraska.
“And by that I don’t mean a specific industry, but rather the type of company the fund invests in – disruptive innovation. When liquidity and optimism are high, these companies attract capital. We saw that last year. Essentially, it has.” thematically a highly concentrated portfolio, “says Johnson of Wood.
While Ark’s unique problem of holding high percentages of less-traded companies is arguably the largest unconfirmed risk factor for his funds, Johnson’s observation is another problem.
And another problem could soon be felt due to Cathie Wood’s remarkably successful run that helped grow the company’s net worth from around $ 3 billion to over $ 50 billion in just over a year. It’s the falling returns that come with managing large sums of money.
“When you’re really ‘hot’ you get a lot of money to manage and it’s just a lot harder to navigate. Because the best options tend to be in smaller stocks, which are the most mispriced, and when you have a lot of money, man can’t really invest in them because they stop moving the needle, “says Dorsey.