Are ARK Invest ETFs potential money traps?

Over the past 1 year, Cathie Wood’s ARK Invest ETFs have delivered extraordinary returns to its shareholders.

Looking at ARK Invest’s flagship ETF, the ARK Innovation ETF (NYSEMKT: ARKK), if you were to invest $10,000 a year ago, you would have already double your money. Apart from ARK Innovation ETF, there are 4 more actively managed ETF under ARK Invest:

• ARK Genomic Revolution ETF (NYSEMKT: ARKG), 
• ARK Next Generational Internet ETF (NYSEMKT: ARKW), 
• ARK Fintech Innovation ETF (NYSEMKT: ARKF), and 
• ARK Autonomous Technology & Robotics ETF (NYSEMKT: ARKQ)

All of these have returned an average of 150% year to date thanks to the huge increase in valuation of their underlying equities. Comparing this to S&P500’s return, it is clear that ARK Invest ETFs are the clear winners of 2020.

Thanks to their spectacular returns, ARK Invest’s ETFs have been highly sought after by investors throughout 2020 and they continue to receive millions of dollars inflows daily, even today. However, as the asset under management (AUM) of its ETFs grows bigger and bigger, it has led to a significant holding in certain companies.

This has caused some investors to be worried about potential liquidity issues if redemptions were to surge given that some of the underlying stocks have relatively illiquid shares.

In this article, we would learn more about ARK Invest’s ETFs and also take a look at the worries and see if it is a cause of concern.

ARK Invest’s philosophy

Firstly, unlike many passive ETFs that track the index, most ARK’s ETFs are managed actively by its team. This stems from the believes that active management could allow the team to capture long-term investment opportunities in the market. ARKs holding also focus solely on disruptive innovation like Genomics, Autonomous technology & Robotics, Fintech solutions and Next-generation Internet.

To cater to different investors, ARK invest has provided thematic ETFs for investors who want to bet on a certain disruptive innovation like genomic.

Here are the 5 actively managed ETFs ARK Invest have.

ARK Innovation ETF (NYSEMKT: ARKK)

This the flagship ETF by ARK Invest and it is by far the largest in terms of AUM. As of March 2021, its AUM is $24,902 million. As a comparison, the SPDR Straits Times Index which tracks Singapore’s STI index only has an AUM of $1,270 million (converted to USD).

For investors buying this ETF, you will be buying into the general theme of disruptive technology. Companies included in this ETF comes from various disruptive sectors like genomic, next-generation internet, fintech solution, and autonomous technology. As such, if you are unsure of what ARK ETF to go for, this would be the one.

Top 3 holdings:

• Tesla which produces EV, solar and clean energy.
• Square Inc, a fintech company that provides seller tools to start, run and grow their business and also peer to peer payments for individuals.
• Roku which offers access to streaming media content from various online services like Netflix and Amazon.

ARK Genomic Revolution ETF (NYSEMKT: ARKG)

Out of all the actively managed ETFs by ARK Invest, the ARK Genomic Revolution ETF is one of the more popular options due to the marketing efforts by ARK Invest which has raved about its potential growth.

Companies within ARKG are focused on the health care sectors especially on disruptive technology like CRISPR, Targeted Therapeutics, Bioinformatics, Molecular Diagnostics, Stem Cells, and Agricultural Biology. These disruptive technologies have the potential of enhancing the quality of human lives and are what ARKG is focusing on.

Top 3 holdings:

• Teladoc health focuses on providing virtual healthcare services.
• Pacific Biosciences designs, develops, and manufactures sequencing systems to help scientists solve genetically complex problems.
• Exact Sciences Corporation provides cancer screening and diagnostic test products.

ARK Next Generational Internet ETF (NYSEMKT: ARKW)

ARK Next Generation Internet ETF focuses on companies that are expected to benefit from the next generation of the internet like cloud technology, big data, and the internet of things. These companies may be in the field of cloud computing & Cyber Security, E-commerce, Big Data & Artificial Intelligence, Mobile Technology and Internet of Things, Social Platforms and Blockchain & P2P

Top 3 holdings:

• Tesla which produces EV, solar and clean energy.
• Grayscale Bitcoin Trust BTC an investment trust which provides investors exposure to bitcoin.
• Square Inc, a fintech company that provides seller tools to start, run and grow their business and also peer-to-peer payments for individuals.

ARK Fintech Innovation ETF (NYSEMKT: ARKF)

The ARK Fintech Innovation ETF focuses on the theme of fintech innovations in which the product or service could potentially change the way the financial sector works. This includes transaction innovations, blockchain technology, risk transformation, frictionless funding platforms, customer-facing platforms, and new intermediaries.

Top 3 holdings:

• Square Inc, a fintech company that provides seller tools to start, run and grow their business and also peer-to-peer payments for individuals.
• Paypal, a digital payment company that enables digital and mobile payments.
• Silvergate Capital Corporation, a holding company for Silvergate Bank that engages in the provision of banking and loan services.

ARK Autonomous Technology & Robotics ETF (NYSEMKT: ARKQ)

Last but not least is ARK Autonomous Technology & Robotics ETF. As the name suggests, the companies found in this ETF are those that focus on autonomous technology and robotics. Some of the fields include autonomous transportation, robotics and automation, 3D printing, Energy storage, and Space Exploration.

Top 3 holdings:

• Tesla which produces EV, solar and clean energy.
• Baidu whose main business is in its search engine but has been involved in exploring self-driving technology, which is why it is in this holding.
• Trimble Inc provides advanced location-based software solutions like GPS.

ARK Invest’s liquidity Issue

Alright, let’s get back to the problem of Ark ETF liquidity issue. During the market sell-off in late Feb to early March, Ark Invest’s flagship fund ARKK had recorded a half-billion-dollar redemption.

As investors rush to sell their holdings, analysts were worried that the fund would find it hard to exit some positions especially in a handful of companies whose shares are relatively illiquid.

As ARK ETFs mainly focus on disruptive technology firms, most of these companies are still relatively small in terms of market capitalization and the volume of shares traded daily is low too. It is no wonder there are such worries. As reported by Reuters, some of these companies include therapeutic discovery company Compugen and 3D printing firm Stratasys whose daily share trading is tiny compared to the overall ETF’s turnover. 

For example, in the case of Stratasys, its average trading volume stands at 2.7 million. Compared to the 12 million shares ARK Invest owns, it would take days just to liquidate such companies. This is similar for Compugen which has an average trading volume of 1.44 million compared to the 17 million shares currently owned by ARK Invest.

No major issues in the short term

Of course, If ARK wants to liquidate within a day or two, it can. However, this often comes at a lower selling price which may not be favorable to its shareholders.

While the concern is true to a certain extent, I do not think that the redemption is a cause of concern for ARK Invest for now.

As shown in the diagram below, you can see that for most of the days, the fund flow is typically net inflow instead of outflow. Meaning to say, ARK Invest does not have the problem of forced liquidation of its holding (even those illiquid ones).

However that is not to say this problem will not arise in the future. ARK Invest currently receives a lot of attention from investors due to its performance. Should ARK Invest’s performance starts to decline in the future, many investors may start to pull out and this could become a problem.

Shorting pressure

Another reason for worries would be selling pressure by short-sellers. With the high ownership ARK Invest has in certain companies, ARK invest does not have much liquidity to play around with.

Let’s take a look at the 2 companies mentioned above. ARK Invest is currently the top owner of Compugen and Stratasys, accounting for more than 20% stake in both cases:

This situation creates an opportunity for short sellers to take advantage of. Whenever there is selling pressure that causes ARK ETFs to trade below their net asset values, ETF arbitrageurs (People who take advantage of mispricing in the market) could redeem the fund for the underlying holdings and then sell the underlying holdings for a profit. This would result in a vicious cycle and cause further selling pressure on ARK ETFs.

As ARK Invest’s AUM grows, this issue will only grow. This is because ARK invest has to find ways to invest that money. They could either find more attractive companies to invest in* or increase the allocation in existing holdings which has resulted in large holdings in certain companies.

*Note that ARK is looking to Asia which would increase the number of potential companies they can look at, however it takes time to identify good companies as lots of research has to be done.

ARK Invest’s Opinion

To address investors’ concerns, Catherine Wood has talked about ARK invest liquidity on a webinar. If you are interested to watch, here is the link, else here are the takeaways from it.

Increase holdings in large-cap liquid stocks

With more cash inflows, ARK invest is planning to increase its holdings into large-cap liquid stocks. Such stocks include the well-known FAANG stocks – Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Alphabet (GOOG).

These large-cap liquid stocks would then be considered like ‘cash’ in which during downturns like that one we had in late February, ARK would be able to sell these larger cap liquid stocks in favour of their smaller illiquid stocks (which would likely be hurt more during such a crash).

ETF structure provides more room to play

When there is an outflow from an ETF, it does not mean that ARK has to sell all its underlying just to provide the liquidity to the ETF. Instead, ARK could choose to sell more liquid stocks instead of illiquid ones which could be mispriced during corrections.

With the ETF structure, even with record outflows, ARKK’s discount to NAV peaked at roughly -0.05%, as such, we should not worry too much.

High liquidity when exiting

When an investment turns bad for ARK, they do not have trouble exiting such positions as, during the dips, there would be an increase in buyers seeking opportunities to buy the share at a low. This allows ARK to get out quickly.

Personal Opinion

From the webinar, you could see that Cathie Wood understands the importance of liquidity and is actively ensuring its fund does not get hurt by it. Nonetheless, ARK Invest ETFs do come will their risk, however for those who are willing to take this risk, you would be able to reap the rewards in terms of higher returns if ARKs investments come through.

While I currently do not have any position in ARK Invest ETFs, going forward, I am looking to add some position when the time is right.