Cathie Wood’s firm, Ark Investment Management, or Ark Invest, is one of the hottest asset managers on Wall Street today. Last year alone saw assets under management soar more than tenfold, surging from $3.1 billion to $34.5 billion as a combination of stellar performance and fund inflows ballooned its assets.
As of early February, Ark had amassed an AUM of more than $50 billion, as more than $11 billion in inflows hit Wood’s funds following a stellar 2020.
In short, Cathie Wood and Ark Invest are the envy of fund managers everywhere. For now.
There is one risk, however, that investors piling into Ark ETFs might not be taking as seriously as they should.
The Nature of Fund Flows
Investors chase returns, piling in when funds run “hot.”
And they predictably do the precise opposite when funds hit a cold streak.
For what it’s worth, this is a troublesome 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 between 1991 and 2004, timing decisions caused equity fund investors to underperform against the funds themselves to the tune of 1.56% annually. That adds up, especially when compounded every year.
A Morningstar study for the aughts, running from 2000 to the end of 2009, found an almost identical tidbit: The average equity and bond fund returned 3.18% while the average investor earned just 1.68% annually — 150 basis points less per year.
What does that mean? It simply confirms that investors tend to chase returns, piling in at elevated levels and selling out when things take a turn.
It also means that when Ark hits a period of underperformance, we can expect redemptions. And that’s when things could get ugly.
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Unlike mutual funds, ETFs aren’t forced to keep cash on their books to guard against the case of investors selling or redeeming fund shares. Instead, through a process of unit creation and redemption, authorized participants essentially have to sell shares of the underlying securities when investors redeem their ETF shares.
The problem with Ark arises due to the large number of holdings it has in which it owns a huge percentage of outstanding shares. Naturally, these tend to be smaller companies with lower daily trading volumes.
If investors begin selling Ark ETFs, the underlying securities will need to be sold. As of Feb. 13, there were a full 25 companies in which Ark Invest owned more than 10% of outstanding shares.
One question that might arise here: Does that mean the problem with Ark is one of liquidity or fund flows?
“I would say those two are very linked. I’d say it’s a potential illiquidity problem that will be realized if there (are) a lot of outflows,” says Edwin Dorsey, author of The Bear Cave newsletter.
“If there’s inflows then it doesn’t matter how liquid you are because you just keep buying this stuff up. It’s kind of like if a bank is undercapitalized but everyone keeps depositing money — there’s never going to be a bank failure,” Dorsey says.
“So it’s a liquidity problem that will get to the forefront of everyone’s mind if there’s a lot of sudden outflows,” he says.
Knowledge of Ark’s concentration issues here doesn’t just make exiting positions problematic — it makes its funds susceptible to being front-run by hedge funds selling or shorting some of these more illiquid names, Dorsey says.
“If people start saying, ‘Oh, Ark’s performing poorly; retail investors are starting to redeem — let’s turn them upside down,’ you’re not just going to have Ark’s selling pressure hurt these illiquid stocks, you’re going to have all these funds shorting these names, pushing them lower, expecting Ark to do that next week,” he says.
It’s a feedback loop, with the very real potential to compound on itself. When Ark has to sell large amounts of small companies, flooding the market with shares, it’s not going to get a great price on the open market.
Of course, this drives down the performance of Ark ETFs themselves, making further redemptions more likely if the well-known tendency of investors to sell in downturns holds true.
Ark certainly recognizes how concentrated its portfolio has become in certain names. On Friday, the fund family quietly amended its prospectus to change its own rules on ETF portfolios; Ark ETFs can now invest more than 30% of their holdings in a single security and can own more than 20% of a single company.
To put those (now abandoned) limits in context, many diversified mutual funds will limit themselves to putting 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 previous concentration rules may stop the company from inevitably running afoul of its own rules should current trends continue, but it merely compounds the problem lamented by Dorsey and others.
Either way, a period of underperformance is likely to come soon — even if it’s not due strictly to liquidity issues.
“I think the biggest risk to Cathie Wood and ARKK is the concentrated nature of the holdings,” says Robert Johnson, a finance professor at Creighton University in Omaha, Nebraska.
“And, by that, I don’t mean any specific industry, but more the nature of the kind of firms the fund invests in — disruptive innovation. When liquidity and optimism are high, these kinds of firms attract capital. We have seen that over the past year. In essence, she has a highly concentrated portfolio thematically,” Johnson says of Wood.
Although Ark’s unique problem of holding high percentages of less heavily traded companies is arguably the largest unacknowledged risk factor to its funds, Johnson’s observation is another issue.
And yet another issue may soon rear its head as a result of Cathie Wood’s own remarkably successful run, which helped balloon the firm’s assets from around $3 billion to more than $50 billion in a little over a year. It’s the diminishing returns that come with managing larger sums of money.
“If you’re really ‘hot’ you get a lot of money to manage and it’s just a lot tougher to navigate. Because the best opportunities tend to be in smaller stocks which are the most mispriced, and when you have a lot of money you can’t really invest in them because they don’t move the needle anymore,” Dorsey says.
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