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John Engle
John Engle
Articles (604) 

ARK Innovation ETF: Flood of Inflows Creates Liquidity Drought

Too much concentration has put Cathie Wood's high-flying fund at risk of short seller attack

February 23, 2021 | About:

Catherine Wood (Trades, Portfolio) has become a leading figure in the financial media over the last couple of years thanks to the success of her investment firm, ARK Investment Management. The firm has launched five exchange-traded funds, all of which are dedicated to "disruptive innovation" of one form or another. ARK has beaten the wider stock market handily in recent years, a fact that has not gone unnoticed by investors, who poured more money than ever into its ETFs.

Unfortunately, a flood of capital into concentrated funds can prove problematic for asset managers. In ARK's case, the sheer volume of inflows may have become an issue. Indeed, some analysts and commentators have begun to wonder openly whether the relentless capital flood will eventually threaten to sink Wood's ARK.

A deluge of flows

ARK's flagship fund, ARK Innovation ETF (ARKK), has outpaced the S&P 500 index by a significant margin since its launch in October 2014. With an average annualized return of 39% from launch to January 2021, it is easy to see why investors might want to hitch a ride on Wood's ship.

ARKK's strong performance over the past few years, as well as the rising public profiles of its CEO and analysts, have helped drive capital inflows, as Morningstar analyst Amy Arnott explained on Feb. 18:

"The fund started gaining more attention after its 87% runup in 2017...The fund posted a total return of more than 150% in 2020 and garnered about $10 billion in net inflows for the year, plus an additional $5.2 billion in net inflows so far in 2021 (as of Feb. 11). These torrential inflows make the fund--along with several other Ark offerings--one of the fastest-growing funds in the industry...Ark Innovation's stellar total returns attest to its ability to be in the right place at the right time and take advantage of emerging trends. But a closer look at the portfolio reveals plenty of potential risks."

2020 was clearly a turning point, with a once steady stream of inflows turning into a torrential flood. Having started 2020 with $3.2 billion in assets under management, ARK Innovation entered 2021 with more than $13 billion, a number that has only grown in the early days of the year.

Uncertain market waters

While few asset managers complain about capital inflows, there are reasons to be concerned when specialized funds are forced to contend suddenly with a much bigger profile. This has been a problem for many a fund manager over the years, as Jason Zweig of The Wall Street Journal noted on Feb. 5:

"When you have millions of dollars, you can easily invest in a few small companies. Once you have billions, you may have to spread investments across more and bigger companies; otherwise, your trades could wreak havoc on your holdings. Many fast-growing asset managers have changed their investing style, incurred much higher trading costs or simply suffered a severe decline in performance."

In essence, outsized size can threaten a fund's outsized performance, especially if its investing strategy has limited bandwidth. Wood's funds may be vulnerable to this issue according to Evie Liu of Barron's, who opined on Jan. 21 that ARK Innovation especially may have become too popular for its own good:

"ARK Investment was one of the fastest-growing fund managers in 2020. Now it might be facing a problem due to its exponential growth: The company owns too much of some companies it invests in, which could limit its ability to select and trade stocks freely."

From liquidity flood to drought

High concentration has served ARK well in the past, but it has now resulted in it owning outsized positions in a number of stocks. Yet, as ARK's ETFs, especially ARK Innovation, have ballooned in size, so too has their ownership in numerous individual companies. According to an analysis conducted by FactSet early this month, the ETF holds 10% or more ownership in companies that make up more than 40% of its total assets.

According to a Feb. 13 report by Bloomberg, ARK's funds owned 15% or more of 11 separate companies. Moreover, the firm owns more than 20% ownership in three names: Compugen Ltd. (NASDAQ:CGEN), Stratasys Ltd. (NASDAQ:SSYS) and Organovo Holdings Inc. (NASDAQ:ONVO). Such overly concentrated ownership of individual securities can create significant liquidity issues in the event that capital outflows begin. As Zweig observed on Feb. 5, this could be especially troubling for ARK Innovation:

"If investors sold enough shares of ARK Innovation ETF to cause a $1 billion redemption, that would require 14.5% of the recent trading volume of its underlying holdings, on average, to change hands. For Vanguard Total World Stock ETF, by comparison, a $1 billion block sale would involve an average of only 0.6% of total trading volume in that fund's stocks...An old Wall Street proverb warns that it can be hard to get out of stocks when markets go bad: 'Liquidity is there only when you don't need it.' Another warns, 'When you have a few shares of a stock, you own it, but when you have lots of shares, then the stock owns you.'"

Short pirates scent a prize

ARK's liquidity issues make it vulnerable to more than the market tide, as analyst Edwin Dorsey pointed out on Feb 16:

"ETFs, unlike hedge funds, do not have long-term capital and can rapidly gain or lose assets based on the sentiments of its retail investors. These changing flows can act as a self-fulfilling prophecy for ARK, which invests in relatively illiquid companies...If Ark Invest faced outflows it would need to sell some of its holdings, which could cause them to fall. If hedge funds start front-running the forced selling, Ark Invest's performance could deteriorate further, which would lead to more outflows, then more selling, and then worse performance, and then more outflows, etc."

Opportunistic short sellers may scent a prize to be had by exploiting the firm's over-concentration in various names by forcing it to sell into an illiquid market. With a large number of its top holdings now facing considerable pressure, this risk has only been magnified.

My verdict

Even as ARK's top holdings have suffered in recent days, the firm has thus far shown little concern. That could end up magnifying its issues, as Dorsey observed on Feb. 23:

"ARK seems indifferent to its illiquidity risks.ARK should be treating the situation as a four-alarm fire. Instead, it is just business as usual. The next 48 hours will play a big role in determining what happens next. If things don't change, Cathie's ARK may sink."

ARK Innovation ETF is currently down nearly 9% from its Friday close, even after recovering somewhat in the latter hours of the Feb. 23 trading session. ARK's issues remain unsolved, and I fear they may only get worse if Wood and her team fail to change course.

Disclosure: No positions.

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About the author:

John Engle
John Engle is president of Almington Capital Merchant Bankers and chief investment officer of the Cannabis Capital Group. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin, a diploma in finance from the London School of Economics and an MBA from the University of Oxford.

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