My view on what's going on in the financial markets and the global economy, and a few other things that might interest me from time to time.

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  • tim@emorningcoffee.com

ARK Invest and Cathie Wood

ARK Invest (“ARK”, website here) has garnered an increasing amount of attention recently because this asset management firm, under the leadership of Cathie Wood, runs a series of mostly actively-managed ETFs that have delivered outsized returns compared to almost any benchmark you can think of. ARK’s series of five actively managed ETFs and two index ETFs focus on companies that are considered cutting edge innovators or disrupters. As you might expect, significant above-average returns have increased the amount of assets under management (“AuMs”) in the ARK suite of ETFs. To give you an idea of the growth, the suite of flagship ETFs have seen their AuMs increase from $6.6 billion in early January 2019 to around $43 billion today across the company’s suite of ETFs (a period that includes the creation of a new ETF focused on fintech in February 2019). The strong returns in the existing ETFs have also spawned interest in the creation of new ETFs under the ARK umbrella focused on disruptive companies, with the eighth such fund – focused on space technology (“ARKX”) – in the process of being created. Ms Wood, the asset management company’s founder, CEO and CIO – is increasingly visible in the media, but until recently, not many people had heard of ARK in spite of its interesting albeit unusual strategy. I would like to discuss some of the interesting things about ARK in this article.


ARK Investment Management LLC was founded by Cathie Wood in 2014. Ms Wood had extensive experience in investment management and as an economist over many years before starting ARK. She worked at Capital Group, Jennison Associates (18 years), Tupelo Capital Management (co-founder) and AllianceBernstein (12 years). Over this period, Ms Wood refined her focus on and belief in companies focused on disruptive technologies, many that are under the radar screen of traditional sell-side research analysts and investment firms. ARK Invest has a rather unique approach and strategy, both in terms of the firm’s focus and format / composition of its offerings. ARK has been focused on disruptive technologies since its founding and remains fully committed to this strategy. The investment company hired a team of research analysts who specialise in identifying the most attractive companies in disruptive industries like fintech, robotics, biotech, and several other areas. The format of ARK’s offerings in the US is principally ETFs.


As far as the firm’s history, Ms Wood is the founder, CEO and CIO of ARK, and the majority shareholder of the management company. Resolute Investment Managers has also been involved in ARK from near its inception. Resolute is a diversified asset management company based in Texas that partners with asset managers, like ARK, to deliver distribution, operational and administrative services. Resolute had an option that it acquired in 2016 which would have allowed it to take control of the management company (i.e. ARK Investment Management LLC) in late 2020. However, the ARK management company instead bought the option back from Resolute, so that Ms Wood continued as the controlling shareholder. In exchange for purchasing the option, ARK apparently agreed to a long-term contract with Resolute for its support functions. One of the five board members of ARK is in fact Gene Needles, who is the chairman and CEO of Resolute. ARK Invest also has a strategic relationship with Nikko Asset Management (“NAM”). In 2017, Nikko invested in the ARK management company in exchange for exclusive marketing rights for the ARK disruptive strategies in Asia, expressed mainly through a series of mutual funds with similar strategies to the various ETFs offered by ARK in the US. Tomoko Ueda, Global Head of Strategic Planning and Management at NAM, is another of the board members of ARK.


According to an article in Bloomberg dated September 26th 2020 (here), ARK had 27 employees on that date. The article described the employee base like this: “The 27-person team -- one-quarter people of colour, 30% women and most in their 20s -- has built funds around companies with the potential to shape the future, including fintech, space and imaging.” Ms Woods obviously has focused not only on diversity, but also on hiring young research analysts that are “connected” to the world of tomorrow and are able to spot and read trends in social media, etc. There is some debate, perhaps valid, that the firm – including its analyst team and Ms Wood – does not associate the “opportunity” that its disruptive stable of companies offer with their share prices, meaning stocks are bought with little consideration to their intrinsic value. I would probably fall into this camp, but this is a minority view (and probably shrinking) because, for the time being, the ARK Invest ETFs are delivering strong returns that are the envy of many other actively managed funds.


As you might know, there has been a gradual shift over many years from active management of retail funds to passive funds which simply track indices, of which there are many. As I wrote about in emorningcoffee.com in February 2020 (here), Vanguard was the pioneer of low-cost passive mutual funds that track indices, with the first such mutual fund becoming available in 1975 – the First Income Investment Trust – which tracked the S&P 500. The first exchange traded fund, or ETF, sprung up in 1993 and was created by State Street Bank. Perhaps not surprising, the first ETF also tracked the S&P 500 index. This index – the SPDR S&P 500 ETF (“SPY”) – is in fact the largest ETF today with around $325 billion dollars in its fund. According to statista.com, there are 7,602 ETFs globally with $7.74 trillion of assets. 73% of ETFs (by assets) are in North America although Asia is the fastest growing market today. The ETF business in the US is dominated by three large firms which together have around 80% of the ETF market – Blackrock (iShares), State Street Bank (SPDRs) and Vanguard. A recent Forbes article (here) said that nearly all ETFs are passively managed funds that track an index, and that only 2% or so of ETFs are actively managed. This means that ARK’s strategy involving a suite of mostly actively managed ETFs is unusual vis-à-vis most ETFs. Apparently though, the trend towards more actively managed ETFs is increasing, perhaps driven by the amazing success to date of the ARK ETFs.


Before getting into the interesting details of ARK, I want to present some of the differences between mutual funds and ETFs and their respective mechanics, because I think it is relevant to understanding ARK. One important difference is that ETFs are listed on exchanges and are bought or sold in the open market accordingly, just like stocks or bonds, whilst mutual funds are not traded but rather must invest incoming cash and provide liquidity for redemptions daily. Mutual funds, not dissimilar to other asset managers running third-party money, can face pressure from excessive inflows because they have to invest the money. Similarly, they face pressure from redemptions because they need to provide liquidity to satisfy selling investors on a daily basis. In the case of the former, excessive inflows can create problems because a portfolio manager actively managing a fund might run out of interesting stocks in which to invest or might run into concentration limits, both of which can jeopardise alpha as far as their historical returns. In the case of ETFs, higher demand is expressed in the form of a higher ETF price, not inflows into the ETF, and this pushes up the price of the ETF. Even so, the price of the ETF needs to stay as close as possible to the price of the underlying basket of stocks, known as the net asset value (“NAV”). Both the NAV and the ETF price will ordinarily appreciate (or depreciate) in lockstep. When the NAV and the ETF price get even slightly out of line, there is an arbitrage pricing system that brings the prices back together, adjusting for excess or slack demand for the ETF through the creation or destruction of ETF units. This mechanism involves Authorised Parties (“AP”) – normally a group of broker-dealers, banks and/or institutional investors – that arbitrage away differences in the value between the underlying basket of stocks (or other assets) that comprise the fund and the price of the ETF. (For ETFs that track indices, APs also make adjustments to the ETF basket composition when there is a rebalancing of the index.) Arbitrage is simple if you think of it this way – you sell what is expensive and buy what is cheap, pushing the prices together. If an ETF is “hot” and in high demand causing its price to exceed the NAV, the ETF sponsor issues “creation units” (i.e. new units of the ETF) through its AP network that go into the secondary market, in exchange for a matching basket of stocks that are purchased in the open market by the APs and delivered to the ETF sponsor. The converse is true when the ETF price is less than the NAV. In this case, the ETF would sell a basket of shares in the open market via its APs and buy existing ETF shares, essentially shrinking the ETF. In summary, strong inflows mean ETF units are in demand and new units must be created, and strong outflows mean an ETF is not in demand and units must be destroyed.


Just before technology stocks came under pressure in late February, I found an article on the NASDAQ website that mentioned how the ARK Invest flagship Innovation fund (ARKK) increased its units 6.3% in one week. This magnitude of creation activity is clearly unusual and reflects excessively strong demand for an ETF, perhaps not surprising given the appeal of many of the stocks held by the ARK Invest ETFs. More recently as the technology sell-off accelerated, the shoe was on the other foot as some of the ARK ETFs were forced to sell their baskets of stocks and buy their ETF units, as the ETF prices fell below NAVs. Having said this, I believe that changes in AuMs of ETFs are primarily caused by changes in NAVs, with unusual arbitrage activity contributing only occasionally. As an aside, I am not going to discuss how unusual arbitrage activity around ETFs can exaggerate movement in share prices, because it is not the focus of this article, although you can imagine the potentially dangerous feedback loop up or down such activity might cause. A recent article in the Financial Times“The resilient mechanics within ARK ETFs” – discusses this topic as it pertains to ARK Invest in much more detail, should you want to dig deeper.


Now it is time to focus on ARK. As I mentioned earlier in this article, what makes the ARK Invest suite of ETFs different from most other ETFs is that most of the ARK ETFs are actively managed which is relatively uncommon in the big world of ETFs. The ARK ETFs have other differences too. The funds are all thematic as far as their focus on companies that are considered disruptive innovators. The table below lists the seven ETFs in the ARC Invest suite, the first five of which are actively managed and the last two of which track indices.

ARK also offers managed accounts in each of the above strategies (along with two others – mobility-as-a-service and space exploration), as well as a mutual fund in the US for the Innovation strategy and five mutual funds in Japan, offered through NAM. I also read recently that ARK is about to launch an eighth ETF focused on space and related technology. As you can see in the table above, ARK Innovation (ARKK) is the flagship ETF, with over $21 billion in assets in this table at the time I extracted the table, more than twice the size of the company’s next largest fund, ARKG.


All seven ETF’s currently under the ARK Invest umbrella have relatively few holdings (between 30 and 55). In addition, the holdings tend to be concentrated, with the top 10 holdings in the five actively-managed ETFs accounting for between 40% and 50% of the portfolios. Therefore, the portfolios are not only thematic but are also very dependent on the performance of their largest holdings. In addition, it is not uncommon for more than one of the ARK ETFs to hold the same stocks, since their strategies overlap at the edges. For example, several companies you will know well are held across two or three of the ETFs, including Tesla (three ETFs/8.1% of AuM), Square (three ETFs/5.0%), Roku (two ETFs/3.7%), and Zillow (three ETFs/3.2%). When ARK has it right, these attributes provide a turbo-charged return on the way up, but equally, the concentration in select (and highly correlated names) makes the ETFs susceptible to harsh selling pressure on the way down.


The table below shows the major holdings in aggregate of the five actively-managed ETFs, all of which have over $1 billion of AuM, so you can see how dependent the funds are on the performance of several specific stocks.

Although there is unusual concentration, and hence dependency, of a few companies across the ARK suite of ETFs, there is also some concentrated holdings in the various companies by ARK. For example, as the table above illustrates, ARK ETFs own 11.2% of Invitae Corp (NVTA) and 10.2% of Crispr Therapeutics (CRSP), both significant and important as far as ARK’s influence on these company’s shares. I did not look at other holdings, but one issue I have read about is that as you move down ARK’s holdings (by size) into smaller companies, the collective ARK ETF interest can be material as far as ownership of the companies, perhaps problematic if one of these stocks has to be reduced or liquidated should sentiment change quickly.


In terms of expenses, the ARK ETF family has higher expense ratios than passive index-based ETFs for the simple reason that it has higher infrastructure costs. This should not be surprising in that the company employs a talented group of analysts to help it select the most attractive stocks for the strategies on which it is focused. Fund management fees are 75bps for the five actively-managed funds and are slightly lower for the passive 3D Printing ETF (66bps) and the ARK Israeli Innovative Technology fund (49bps) (source: ETF.com). This compares for example to management funds on large index funds that are normally in the 7bps to 20bps/annum range.


As you might expect given what has been going on with technology stocks the last few years – especially the new tech / high flyers – the ARK ETF funds have generated significantly better returns that the Nasdaq 100 and probably most hedge funds. The five actively managed ETFs have all significantly outperformed the Nasdaq 100 over the same period. The flagship ARK Disruptive Innovation (ARKK) ETF delivered an average annual return of 73.3% over the two+ year period from January 1 2019 to now (March 9th), nearly double that of the NASDAQ 100 which has delivered an average annual return of 37.8% over the same period. Although returns have been lower for both over five years (since January 1, 2016), ARKK has still delivered nearly double the per annum return compared to the tech-heavy NASDAQ 100. In fact, the other ETFs in the ARK suite have also substantially outperformed the NASDAQ 100 over both the two and five year periods, and in nearly every year. The table below illustrates the return of the funds (price action only, ignoring dividends) over the last five years. The returns in green in the middle section of the table indicate outperformance of the fund in a given year vis-à-vis the NASDAQ 100.

Before leaving a discussion on returns, the graph below from YahooFinance.com provides a good depiction of the five actively-managed ARK ETFs compared to each other, and to the NASDAQ 100, over two years.

Personally, I believe that Ms Wood is very good at what she does. She has appeared more frequently in the media over the past year because the stellar returns of the ARK ETFs have caught the attention of investors and pundits alike. Even so, I personally do not find Ms Wood nearly as shamefully self-promoting as many of the hedge fund managers and, more and more often, the many SPAC sponsors that exist today. She articulated a strategy around disruptive technologies at the creation of her investment company in 2014 and has stuck to her guns. She is clearly passionate about her mission and is committed to her strategy. From the perspective of investors, one or more of the ARK Invest ETFs might make perfect sense in a portfolio, especially for those investors with a long-term horizon that can weather bumps in the road, and who firmly believe that disruption will be the key to superior investment returns in the future. The ARK ETFs will be subject to wild gyrations because there is unusual concentration risk and high correlation across the holdings, but this is disclosed and known (and is updated daily). In fact, we just witnessed this over the last couple of weeks as the new tech names came down to earth, not due to operating performance, but rather due to inflated multiples. When you buy an ARK Invest ETF, you should know exactly what you are buying. In exchange for the 75bps management fee, ARK Invest offers investors a strong team of research analysts that are extremely competent as far as understanding disruptive technologies, whether these be in e-commerce, cloud, internet, finance, robotics, biotechnology or other industries subject to disruption.


An ARK ETF is also worth considering on the short side or in the form of puts if you wish to hedge against a long position in some new technology names / “high flyers” that you might own in your portfolio. Of course, unless your portfolio mimics the ARK ETF portfolio perfectly, it will be far from a perfect hedge. Still, recent experience has shown that when the expensive stocks that comprise most of the ARK ETF holdings come down to earth, they tend to come down fast and together. The correlation amongst these sorts of stocks is very strong. If you wish to speculate, a similar position on the short side can serve as a view on the very expensive valuations of many of the stocks held in the ARK ETFs today, although this has proven to be ill-fated since the beginning of the pandemic due to unusually accommodative monetary and fiscal policies around the world, most pronounced in the US, which has pushed stocks nearly across the board higher and higher, with no end in sight at the time I am releasing this article.

 

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