ARKK is an actively managed ETF which invests in companies that benefit from the advent of a new product or service that drastically changes the way the world work.
ARKK is managed by ARK Investment Management LLC, whose founder is Cathie Woods.
Merit of ARKK vs Index investing
One may ask what’s the difference between ARKK and indexes like the VOO or QQQ that tracks the S&P500 and the NASDAQ.
As mentioned, ARK is an actively managed ETF, as the name suggest, fund managers diligently run the ETF with the aim to give investors market-beating performance.
On the other hand, indexes such as VOO and QQQ are passive investments that mirrors the index.
In 2020, ARKK delivered a staggering 152.2% return to it's investors while VOO and QQQ clinched 18.35% and 48.60% returns.
Investor may be skeptical, is ARK’s over performance a one occurrence?
Our team has done the math, if we exclude 2020’s stellar performance, we found that ARKK has indeed outperform the benchmark since 2015.
However, investors should note that actively managed ETFs have a higher expense ratio compared to passive index ETFs.
For comparison, ARKK has a 0.75% expense ratio while VOO and QQQ has 0.03% and 0.20% respectively.
It is no wonder Cathie Wood has become synonymous in the investing world, with many comparing her to legends such as Warren Buffet and Benjamin Graham.
The remarkable performance ARKK brought about has seen record inflows into her fund.
Cathie Wood has said “ Passive investing is unlikely to keep pace with the exponential growth of the five innovation platforms… In our view, S&P is depriving bench-mark sensitive investors of some of the most important investment opportunities in the world, like Tesla.”
Thus, putting our money in the hands of ARKK may not be a bad investment decision after all.
What is ARKK made of
ARK is made of thematic multi-cap exposure to innovation across sectors, with low correlation of relative returns.
It is diversified and conducts top-down and bottom-up research to identify innovative companies.
To date, it’s top 5 holdings are Tesla, Roku, Crispr Therapeutics, Square and Teladoc health.
How has it evolved it's allocation
Our team dug up ARKK 2016 fact sheet and came up with some findings.
Then, it was focused on 3D printing. 14% of the portfolio is made up of 3D printing and it was the top allocation.
Gene therapy, the hype investment theme today was only at 3%
Today, it is evident that there are drastic changes where 3D printing allocation fell to 6% while Gene Therapy has increased to 8.9%
Another interesting finding is ARKK’s conviction in Tesla since 2016.
One of the main reasons why ARKK managed to outperform is attributed to Tesla’s terrific performance.
Back in 2016, Tesla was ARKK’s second largest allocation at 9% and today it has increased to 10.8%
Thematic Investing Risks
ARK utilises thematic investing to capture disruptive innovation.
Thematic investing is an approach which focuses on predicted long-term trends.
Instead of investing in specific companies or sectors. It enables investors to access structural, one-off shifts that can change an entire industry.
However, thematic investing is extremely difficult.
The challenge with thematic funds is knowing whether you have found a long-term trend or a very short-lived fad.
The Macro-economic trend must play out as expected. There are uncertainty to whether companies are able to achieve break-through from R&D or incur high burn rate with no results.
Themes can be impacted by a range of factors. Such as changes in government policy, interest rates, geo-political climate and advances in technology.
Even if one were to spot a lasting theme, it would not bring about significant out-performance if he/she were late to catch on to it.
The future prospects of the company may be priced in and reflected in the stock price.
Picking the right company for a given theme will be a greater challenge. No one will be able to predict which company will outperform the other.
It is only evident down the road and history has showed us that many active funds came crashing down.
Buffett wrote in his 2016 Berkshire Hathaway annual shareholder letter "My regular recommendation has been a low-cost S&P 500 index fund."
In addition, he has instructed the trustee in charge of his estate to invest 90 percent of his money into the S&P 500 for his wife after he dies, Buffett told CNBC’s Becky Quick in an exclusive interview on “Squawk Box.”
This segement highlights the multitude of risks involved. It would be wise to take Buffet's words into consideration when it comes to investing.
ARKK's liquidity issues
Besides ARKK’s adoption of thematic investing, there are concerns over the liquidity of it's holding.
In Feb 2021, ARKK saw a record outflow of almost half a billion (456M) when bond yields surged anew.
Data showed investors pulled a record amount of cash from the firm during the tech selloff.
An article by Reuters highlights the severity of the issue “According to some who watch the fund closely, a far bigger problem could be it's 15% plus stakes in a handful of companies whose shares are relatively illiquid and potentially hard to exit when redemptions surge.”
We did some research and crunching of numbers. Indeed, there are some holdings that take more than 5 days to exit.
To derive how many days it takes to sell, we used:
(number of shares held)/ (average trading volume)
The companies are Compugen, Syros, Cerus and Iovance. Below, I’ve attached our research.
ARKK’s performance and popularity has caused many investors to mirror their holdings, commonly known as copy trading.
When a downturn occurs, ARK will be competing with retail investors for liquidity.
Not only that, the presence of short sellers and hedge funds will be looking to exacerbate ARKK’s downturn.
This is supported by another article by Reuters where it writes “The pressure on the fund this week has lured in short-sellers, with 100% of Ark Innovation shares available for shorting out on loans.”
Another article by analyst Edwin Dorsey has pointed out “ETFs, unlike hedge funds, do not have long-term capital and can rapidly gain or lose assets based on the sentiments of it's retail investors.”
ARKK’s ETF trades are online and highly tracked. Hence when market goes south, competitors will be looking for ways to profit by front-running them.
As a result, ARKK may either have to sell at much lower prices or be forced to sell its more liquid holdings.
Both results in a lose-lose situation and hence investors should be wary and know that while it has deliver stellar results, it comes with risks.
Past performances do not indicate future
ARKK’s out-performance wasn’t a phenomenon.
In fact throughout the years, there were funds that achieved remarkable growth rate. Yet, came crashing down.
We have witnessed the the fall of Gerald Tsai in the 60s, Peter Lynch in the 80s, Tech Funds in the 90s, CGM Focus Fund in the 2000s and the list continues.
In the following segments I will highlight two case studies where fund managers achieved spectacular results but ended up with irreversible losses.
Downfall of Wood Ford Investment Fund by Neil Woodford
Neil Woodford, he was UK’s best-known stock picker. He achieved “star” status following 25 years of market beating returns with Invesco Perpetual.
In 2014 he launched his own Wood Ford Investment Fund and it was a resounding success.
Free of restrictions and the control of past bosses at Invesco, he made many risky investments.
He sometimes chose to put money into businesses with shares not listed on a public stock exchange and his style was based on conviction.
One of those conviction was a smooth outcome from Brexit, but politics has not played out that way.
This risk is highlighted above where I explained how thematic investing is extremely difficult.
Uncertainty over Brexit caused the fund to tumble. Negative sentiments were overwhelming and it caused panic selling.
However, the fund purchased a myriad of small-cap, illiquid stocks which led to inability to exit trades.
Investors were told they were not able to redeem their investments and the fund was suspended for 28 days.
The closure sparked Europe’s biggest fund management scandal for a decade.
It prompted UK parliamentary probe, investigations from several national regulators and confidence crisis.
For months, investors were stuck in the fund while they aguishly look at the value of their investment dwindle.
Another example of a fallen star: CGM Focus Fund
CGM Focus Fund was the top performing U.S fund from 2000 to 2009.
Heebner, the fund manager was ranked as America’s Number 1 stock picker before losing his Midas touch.
The fund generated 18% annual returns during a decade in which S&P 500 averaged a 1% annual decline.
During the 2000s, he shorted tech stocks during the dot com bubble burst and bought into homebuilder stocks.
By 2005, he sold the peak and moved into energy and commodity.
However, the 2008 global recession hurt commodity prices and the fund lost 48%
The fund plummeted again in 2011 with fears of a slowing economy and it netted a 26% lost compared a 2.1% return for the S&P 500.
In fact ARKK has seen inflows of about $1Bn in certain weeks. I believe ARKK can continue to produce good returns.
However, we should know the inherent risk associated with ARKK fund. That is where the 5% or at most 10% allocation works to control risk.
Nobdody can predict the future no matter how experienced an investor or fund manager is.
Thus, it will be wise for investors move away from Hollywood-style culture of star worship when choosing to invest in fund managers.
Last updated on April 6th, 2021 at 02:31 pm