ARK Investment Management – or ARK Invest, as it usually styles itself – had a great 2020. ARK Innovation ETF (ARKK, Financial), the firm's flagship fund, returned more than 150% last year. Unsurprisingly, that white-hot performance led to a deluge of capital inflows. However, the scale of inflows, which surpassed $10 billion, was surprising.
Alas, it appears the party may be coming to an end for ARK and its high-flying ETFs. As I discussed in a previouis article, ARK's increased size, which has made it a major shareholder in a number of small cap stocks, has created significant liquidity risks. Those risks have only been magnified in the days since, as ARK has attempted to prop up a number of these holdings that have come under pressure.
Trading liquidity for price support
ARK's ETFs hold a variety of stocks, including a number of large, liquid names such as Amazon.com Inc. (AMZN, Financial), in order to capture the full spectrum of disruptive innovation. Moreover, such liquid positions can serve another function, as CEO Catherine Wood (Trades, Portfolio) discussed with the The Wall Street Journal earlier this month:
"Ms. Wood says that as markets rise, ARK diversifies into larger companies. They form a kind of war chest that ARK can tap into 'during downturns, when our less-liquid stocks will be hit disproportionately, giving us better bargains,' she says. In other words, ARK counts on being able to sell some big stocks to buy smaller ones when those become even cheaper—as it did successfully during last year's severe bear market.. .What might happen if the same investors who flung billions of dollars into ARK's funds over the past year yank the money back out? 'Not concerned about it... the market is beginning to understand the exponential growth opportunities out there,' which will create ample liquidity over time, she says."
In other words, liquid holdings can be sold without moving the share price overmuch, allowing ARK to free up cash to support the prices of its smaller, illiquid holdings as needed. As a firm with more than 40% of its assets under management tied up in outsized positions in illiquid stocks, supporting those names is especially important for ARK.
Playing a dangerous game
While selling liquid holdings to provide support for illiquid ones can work for a time, it is a limited strategy and can end up creating more problems than it solves, in my opinion. One potential issue is that lack of liquidity can make a fund vulnerable to targeted attacks by short sellers, as analyst Edwin Dorsey pointed out on Feb. 23:
"By selling liquid holdings to support illiquid holdings ARK is becoming more illiquid. That is what U.K.-based fund Woodford Capital did before suspending redemptions and closing. The hedge funds that may attempt to blow up ARK have more patient and sophisticated capital than ARK's retail base. The strategy of getting more illiquid for temporary support won't work...Any actions taken by ARK will now work against them. If ARK starts selling a big holding, retail may bail and predatory shorts will pounce. This may cause further declines in whatever security ARK tries to sell."
Dorsey's warning appears to have become a reality, based on the recent performance of its most concentrated holdings. Compugen Ltd. (CGEN, Financial), of which ARK holds more than 20% of outstanding equity, is down 33% so far this week. Editas Medicine Inc. (EDIT, Financial), another concentrated holding, is down 20% this week. And that is just the tip of the iceberg, as more than a dozen of ARK's illiquid holdings have deteriorated in recent days on broader selloffs in overvalued small-cap tech and tech-adjacent stocks.
My verdict
This week has certainly seen ARK's strategy put to the test in terms of how it holds up in a period when bullish sentiment falters. Thus far, it has proven on downside protection. Despite its best efforts, many of its big positions in small companies have continued to deteriorate even as it has expanded its already outsized positions.
ARK is already experiencing outflows due to this, putting still more pressure on its illiquid positions. ARK is at the mercy of the broader market, in my opinion. Consequently, I recommend steering clear of ARK's ETFs for the time being.
Disclosure: No positions.
Read more here:
- The Danger of Assuming Stocks Always Go Up
- Berkshire Hathaway: Book Value Growth Still Shines
- ARK Innovation ETF: Flood of Inflows Creates Liquidity Drought
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