Exchange traded funds have many great qualities. They are mostly transparent, low cost, trade in real-time and can have significant tax advantages over other investment vehicles like mutual funds and managed accounts. But like anything else, the structure is not without its weaknesses, and somewhat ironically, the success of one firm demonstrates some of the challenges ETFs and investors may face.
Ark Investments, the top performing asset manager who has been at the forefront of investing in innovation and disruptive companies, has seen its firm’s assets and assets in its flagship fund explode over the past year or so. In January of 2020 the fund had about $1.8B in assets and at the peak earlier this year the fund was at $27B. It is now down to $20B. That’s massive growth for any ETF. Cathie Wood, the founder of Ark, and her team have knocked the ball out of the park from a performance perspective, but that success may come with a cost, and the ETF wrapper may make that cost greater than it would have been in a traditional fund format.
3 Year AUM of the Ark Innovation ETF (ARKK)
Source: YCharts, ARKK AUM
Creating Shares
When ETFs first come to market, there is typically a certain number of shares that are created. These are called “creation units”. A newly launched ETF may come to market with 100,000 shares priced at $25 for a total fund value of $2,500,000. As those shares get absorbed into the market and investor demand increases, authorized participants have the ability to create more shares. Most ETF issuers want to see these “creates”, as it indicates there is demand in the market for their funds and they make their assets under management increase. As more shares are issued through this process, more of the underlying stocks in the fund’s portfolio are purchased. The flip side of creates are redeems – this is when shares are basically destroyed because investors are selling the ETF and demand and investor interest in the open market isn’t there. This results in the sale in the fund’s underlying holdings.
Creates and redeems are not something controlled by Ark, they are a key mechanism for how ETFs shares are issued and retired. And therein lies the potential issue. Ark has no ability to close the fund to new investors. As money has poured in, shares have continued to be created and the companies in the portfolio have continued to be purchased. It’s impossible to tell what type of impact the inflows had on the underlying stocks, but it’s certainly a reasonable question for investors to be asking. As you can see from the chart below as of May 21st, there are certainly some small and medium companies held by the fund.
Source: https://ark-funds.com/arkk (Fact Sheet)
In the mutual fund world, funds have the ability to be closed to new investors. Often times, successful small and mid-cap funds, whose capacity is limited, will do exactly that. They know too many assets can actually be a negative in terms of performance. You can’t close an ETF to investors, so Ark couldn’t do much about its popularity, even if it thought assets were coming in too fast. This could lead to the fund growing beyond a size that might be considered appropriate given its focused nature. This isn’t a major problem as long as flows keep coming in, but can become a problem in a period of significant outflows.
At the current time, there are ten companies in the portfolio where Ark’s stake is worth more than 6% of the total value of the firm based on it’s market cap. The table below shows these companies as well as the size of Ark’s stake relative to the daily dollar volume. Take Proto Labs, #2 on the list. Ark owns 9.29% of the company with its stake through the ETF and its total position size represents 480% of the total daily dollar volume, meaning it would take some time to fully unwind the position. But because redemptions aren’t something Ark can control, selling pressure could be significant on a stock like this if there were a period of significant outflows.
Ark can mitigate this, however, using something called a custom redeem basket. What this means is that Ark can alter the stocks it delivers back to market makers in response to redeems to look different than its market value weighted holdings list. For example, Ark could take its most liquid holdings like Tesla and include them at much higher weights in these baskets to avoid putting too much selling pressure on its less liquid positions. This would help in smaller liquidation events, but also have a big risk associated with it because it would cause its remaining portfolio to have higher weights in the less liquid names. These would become a problem in a more major liquidation event if it ran out of larger names to liquidate.
Source: https://ark-funds.com/arkk (Holding File) and Validea Internal data
Disclosed Holdings
Another feature of most ETFs is that ETF holdings are displayed daily on the ETF issuer’s web site. For all active and passive ETFs that are not considered non-transparent, this is a regulatory requirement. What this also means is that investors can see what positions are being added to or sold in the portfolio the day after the change is made. For most ETFs, this probably isn’t an issue, and many trades can be executed in one day. But Ark, given its size and concentration, isn’t like most ETFs. Not only did its assets increase by 14-fold in a little over a year, but its portfolio is concentrated, holding about 50 positions. This provides an opportunity for other investors to attempt to front run Ark’s trades by predicting what it will do. It also could exacerbate liquidity issues should the fund see redemptions. Some were calling this the “Cathie Wood effect”, where prices would spike up after Ark disclosed a new position. But this could also work on the other direction.
Mutual funds, as most know, only have to report out their holdings on a quarterly basis, so any move a portfolio manager makes isn’t something the market knows about immediately, and even Warren Buffett, gets to delay reporting what he is buying to prevent others from trying to get ahead of him.
Investor Returns
Like stocks, ETFs can be easily bought, sold and traded throughout the day. For the most part, the liquidity is good for investors. But the massive growth in assets in the Ark ETF also means that the vast majority of investors have come into the funds more recently. Few have benefitted from the fund’s recording setting returns over the past five years. Over the past five years, as of the writing of this article, the Ark Innovation ETF has returned 49.9% per year, but as was pointed out in a recent WSJ piece, the money weighted returns of their funds is far, far lower as a result of investors piling in more recently and then seeing the fund pull back.
From an investor return perspective, you could almost argue that more volatile funds that look nothing like the market and can deviate a lot from the standard benchmarks shouldn’t be as easy to trade because this may ultimately be better, not worse, for investor returns over time. Obviously, this isn’t Ark’s fault and it doesn’t take away from the great returns they have produced, but it is interesting to think about whether this phenomenon could be worse in ETFs than traditional funds. And going back to my first point, the fact that the fund can’t close give it no options in terms of limiting this piling on behavior.
As I stated at the outset, ETFs are excellent investment vehicles for a host of reasons. There is probably no vehicle that is better for investors. And Ark’s achievements in the ETF space are amazing and may be looked at in the future as one of the best five-year periods for any active investment strategy ever. But Ark’s success also comes with some downsides, and the ETF structure may exacerbate some of them. Only time will tell whether these issues will prove to be major ones for Ark, or if they could also impact the market as a whole in a worst-case scenario. But either way, that story will certainly be interesting to watch.
Justin J. Carbonneau is VP at Validea & Partner at Validea Capital Management.
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