No One's ARKK: ARK Innovation ETF Offers No Shelter From A Stormy Stock Market

Summary

• ARK Invest's ARK Innovation ETF (ARKK) had a stellar 2020, delivering a 150% return and luring in more than $10 billion in fresh investor allocations during the year.
• Yet even while everything seemed to be coming up ARKK, a few analysts cautioned that the flood of inflows was, ironically, making ARKK's already unusually illiquid portfolio even less liquid.
• 2021 has not gone well for ARKK so far, as the skeptics' warning that its illiquidity made it vulnerable to market reversals has been borne out.
• ARK Invest's Cathie Wood has endeavored to support the flagging prices of ARKK's illiquid positions, but this has accomplished little besides further magnifying the ETF's already dangerous illiquidity.
• ARKK has already fallen more than 30% from the all-time high it set last month; it may get even worse.

Having steered ARK Investment Management (“ARK Invest”) through the turbulent market waters of 2020 to deliver both market-beating returns and record fund inflows across its exchange-traded funds, CEO Cathie Wood looked well placed heading into 2021 to build on her success. Unfortunately, things have played out somewhat differently, with ARK Invest and its flagship fund, ARK Innovation ETF (NYSEARCA:ARKK) making headlines even more than usual over the past two weeks – but for reasons far less positive than has been the norm.

A number of issues have come to plague ARKK of late, including both the recent pullbacks by many of its top positions, and the increasing illiquidity of its holdings overall. As ARKK’s position has continued to weaken, there has been little to offer succor.

Based on ARK Invest’s latest public responses to the incipient crisis facing ARKK and its sister ETFs, I foresee still more rough seas ahead for ARKK. By doubling down on illiquid stocks again and again, the deeper the quagmire ARK Invest risks creating for ARKK. If Wood and her crew cannot right their financial ship, ARKK risks breaking apart on the reefs of public discontent.

A Matter Of Concentration

A growing chorus of analysts, commentators, and investors have been ringing the alarm about ARK’s liquidity problem, or rather, its illiquidity problem. At the heart of the issue is ARKK’s massive positions in a multitude of smaller stocks. Its positions frequently exceed 10% of a company’s total float. Across its funds, it owns more than 15% of nearly a dozen companies, and its position exceeds 10% of the total float of many more.

ARKK’s intensely concentrated ownership in so many names was driven in large part by the rush of inflows to the funds that came off the back of its strong 2020, which saw it deliver a scorching 150% return for the year. The ETF brought in more than $10 billion over the course of 2020, and a further $5.2 billion in the first six weeks of 2021.

Source: FactSet

That is a phenomenal spike for a fund that had started 2020 with $3.2 billion in assets under management. As Jason Zweig noted in The Wall Street Journal in early February, a tide of inflows can be a mixed blessing for asset managers whose strategies involve exposure to smaller public companies:

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.

Some analysts were looking askance at ARKK’s sudden expansion even early, such as Barron’s reporter Evie Liu who sounded the alarm in January, warning that ARKK “owns too much of some companies it invests in, which could limit its ability to select and trade stocks freely." With its assets under management spiking by an order of magnitude, its positions in a number of stocks ballooned as it attempted to mirror its existing portfolio. Consequently, it now owns massive positions in a multitude of companies.

Of course, extremely concentrated ownership in one or more stocks is not necessarily a bad thing, or even a problem. However, it can quickly become one if that stock starts falling back sharply, as ARK Invest has been forced to learn in recent days. Yet, rather than seek to slowly extricate itself from vulnerable positions, ARK Invest has attempted to support threatened stocks by buying even more, a tactic it has opted to employ across several of its concentrated holdings. Indeed, it is part of Wood’s standard operating procedure, according to an interview last month, in which she asserted that, when the market is on the rise, her team works to diversify ARKK’s holdings, moving capital out of illiquid stocks into more liquid large stocks so that, “During downturns, when our less-liquid stocks will be hit disproportionately, giving us better bargains.”

While that strategy might have some merit in certain situations, it is usually good investment practice to approach moves that may reduce liquidity with caution. However, in the case of ARKK, it was largely a moot point since, even at the start of February, ARKK’s ownership concentration in a multitude of names was so great as to raise a number of eyebrows in the investment community. Far from diversifying during the long upswing, ARKK’s assets have become increasingly dominated by illiquid holdings, as Morningstar’s Katherine Lynch observed on February 25th:

As of Feb. 22, 2021, ARKK owned at least 5% of a company's public shares in more than one third its holdings and at least 10% of free float in 10 out of the 55 companies in its portfolio. With this kind of stock ownership, ARKK stands apart from other mid-cap growth funds of its size. Among the 15 biggest mid-cap growth funds other than ARKK, nine had stakes of 5% or more of a company as of Dec. 31, 2020, but only two owned more than a 10% stake. Excluding ARKK, the 15 largest funds have an average ownership of less than 2% of the companies in their portfolios. ARKK averages a 4% stake in its portfolio holdings...the massive acceleration of inflows has seen lead manager Cathie Wood increase her positions in both existing and newer holdings.

Ready or not, the recent market pullback has certainly put ARK Invest’s strategy to the test. Thus far, it has largely failed to live up to its promise.

No Exit

In the face of downward pressure across virtually its entire portfolio over the past couple weeks, ARKK has shifted ever more capital from liquid names to its embattled illiquid holdings. But this has done little to stanch the bleeding, as many of ARKK’s most concentrated holdings have eroded at an alarming rate despite Wood’s best efforts to support a number of smaller stocks.

Source: The Wall Street Journal, FactSet

The bigger the share you own of the company, the longer it takes to get out. That makes extricating oneself from an eroding position a difficult and costly operation. In a March 4 article, Seeking Alpha’s Keubiko used the example of what was then ARK Invest’s single most concentrated holding, Compugen Ltd. (NASDAQ:CGEN), to illustrate the difficulty – and potential danger – of unwinding such an outsized position:

The 15-day daily average volume as of March 3, 2020 is about 1.7 million shares traded per day (up from about 1 million earlier in the month). At 10% of daily volume, it would take ARK about 56 trading days to exit the position. And as a transparent ETF that discloses its trades and positions daily, these positions can be exposed to predatory front-running by short sellers (or simply longs that don’t want to ride the elevator to the basement) if they try to hit the eject button on some of these positions.

Much like quicksand, the more forceful the effort to get out of an overly concentrated position, the deeper one sinks. Compugen has fallen 35% since the start of the year and is down nearly 60% from its 12-month high. Yet ARK Invest has fought doggedly to support Compugen and other similarly threatened holdings, a strategy that is liable to make any future attempts to get out all the more challenging. On March 5th, hedge fund manager Brad Munchen (or Motorhead, as he is better known to the denizens of Seeking Alpha) highlighted Materialise NV (MTLS) as another “crowded long” to which ARKK is badly exposed thanks to the stock’s low average daily volume (“ADV”):

ARKInvest owns 21% of MTLS. Will take them 22 days of ADV to sell. 113 days if they want to be only 20% of ADV.

The 3D printing company is down nearly 70% from its February high, yet ARKK has no easy exit strategy, trapped as it is by the sluggish trading volume. Dumping too much of its position would risk turning a severe retreat into a catastrophic rout, one that might then be repeated across ARKK’s other concentrated holdings.

ARKK’s over-concentration also creates potential regulatory issues, at least in the case where the ETF is effective owner of 10% or more of a company’s stock. With such ownership comes the risk that ARK Invest, or even ARKK on its own, could be classed as an “insider” by the Securities and Exchange Commission, a status that restricts the closing out of concentrated positions at speed. The rule is used mostly to prevent shenanigans on the part of an insider with the power to move the price, but it appears that ARK Invest running afoul of that rule could further slow any effort to extricate ARKK from its quagmire.

Not Just A River In Egypt

In the face of such vulnerabilities, the biggest danger facing ARKK today may be management complacency. In an interview with Bloomberg Radio on February 23rd, Wood dismissed the idea that ARK’s increasing illiquidity was a problem at all. Instead, she framed it as an opportunity, justifying the firm’s decision to continue supporting its concentrated positions:

We love a wall of worry. We saw it on social media, lot of chatter, some of it just waiting for our fund in particular to take a tumble, maybe to buy and some happy to sell and short and all that.

The fear here is that, if the tide of capital inflows that ARKK road through 2020 were to suddenly reverse, it could force redemptions and thus pressure the ETF and its constituent holdings, which could in turn invite opportunistic short attacks, as analyst Edwin Dorsey has pointed out several times in the past month. On February 26th, Wood took to YouTube in an effort to dispel these fears:

There is a misunderstanding of illiquidity when it comes to ETF...As a portfolio manager, I know the difference between an ETF wrapper and a mutual fund wrapper. A portfolio manager in the ETF does not need to worry about flows.

In Wood’s telling, the perceived illiquidity risk faced by ARKK and her other ETFs are nothing but the product of a misunderstanding of how ETFs work and that outflows cannot impact an ETF in the way it would a mutual fund. This line has been carried forward by other members of the ARK Invest team, such as Chief Operating Officer Tom Staudt, who sought to allay investors’ worries in a March 4th interview with ETF Trends:

First and foremost, this is a process, and one where we certainly think about liquidity and capacity. You have to. We monitor risk metrics for every position, and we take the liquidity in those positions seriously. That said, I think that there are key differences between the ETF structure and some negative historical examples, especially when compared to mutual funds, both because of the vehicle difference and because of the strategy difference. One difference is that some mutual funds have had very illiquid – even non-traded — investments. ARKK is still a highly liquid portfolio of traded public equities based on SEC guidelines and financial accounting standards. We believe there is a market every day for every security that ARKK owns.

Staudt essentially denied that there was a liquidity problem at all, citing ARK’s ETF structure as an advantage over such things as mutual funds, which can have far less liquid investments that would be very difficult to sell if they were hit by redemptions or outflows. However, while ARKK’s holdings may all be tradable stocks, and thus liquid to an extent by definition, effective liquidity is often quite different from nominal liquidity, as the cases of Compugen and Materialise show.

Investor’s Eye View

ARKK has been pretty badly battered over the past month. The ETF has fallen more than 30% from its February high of $159.70 to $110.12 at the close on March 8th. However one might try to argue that things look worse than they really are for ARKK. After all, ARKK has held onto most of its 150% gain from 2020, which would suggest that plenty of investors are still sitting pretty on hefty gains even after the recent retreat. Unfortunately, while this may be true in the case of long-term owners of ARKK, those who made their allocations more recently may not be so lucky.

Since the overwhelming majority of inflows occurred during 2020 and early 2021, much of the capital ARKK’s actual dollar losses could actually be worse than the headline figure suggests. With so much more capital under management than it had before, even relatively minor swings could effectively erase the real dollar gains ARK has delivered in years past.

In his recent article, Keubiko did the math on ARKK, determining that a drop of as little as 14% from the prevailing price of $125 to “wipe out all of the dollar value of investment return generated by ARK in this ETF, the brunt of which would be born by latter investors.” With its price standing at $110.12 at time of writing, ARKK is down 12% since Keubiko’s warning. In other words, ARKK may be on the precipice of giving back all the gains it made since its 2014 launch.

Anxiety is clearly running high among investors in all of ARK Invest’s ETFs. Between February 23rd and March 6th, ARK Invest saw $2.6 billion in net outflows across its five funds, or nearly 5% of its aggregate net asset value. Yet ARKK has been spared meaningful outflows to date. Whether that state of affairs can persist is less clear, however. Short interest has intensified rapidly, potentially creating even more vulnerabilities in ARKK’s illiquid positions.

Source: S3 Partners, The Wall Street Journal

Making matters even worse, many of the companies that make up the largest proportion of ARKK’s capital allocations have also been in free fall. Tesla Inc. (NASDAQ:TSLA), long a top ARKK holding, is down more than 37% from the all-time high it set earlier this year. With its illiquid holdings in disarray and many of its liquid positions deteriorating, the challenge of drumming up much needed liquidity has only gotten harder for ARKK.

Source: The Wall Street Journal, FactSet

Ultimately, the evident unwillingness of ARK Invest’s leaders to address ARKK’s illiquidity problems is what I find most disconcerting. ARKK may pull out of its spiral in the event of a strong tech stock rally. That could provide the needed breathing space to unwind some of ARKK’s most dangerous positions. However, that may not be possible if things fail to turn around in short order, or if outflows begin in earnest.

With so much uncertainty looming over ARKK at present, I think the best thing investors can do right now is give this boat a wide berth.

Analyst’s Disclosure: I am/we are short TSLA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.