2/17/2021 ARK ETFs Might Be Too Popular for Their Own Good | Barron's

ETFS FEATURE

ARK ETFs Might Be Too Popular for Their

Own Good
By Evie Liu

Updated Jan. 21, 2021 2:43 pm ET / Original Jan. 21, 2021 8:00 am ET

ARK Investment was one of the

fastest-growing fund managers in
2020. Now it might be facing a
problem due to its exponential
growth: The company owns too
much of some companies it invests
in, which could limit its ability to
select and trade stocks freely.

Cathie Wood, CEO and chief investment officer of ARK

Investment Management.
Led by CEO and founder Cathie
Alex Flynn/Bloomberg Wood, ARK specializes in
ALSO READ investments in disruptive innovations. Over the
Stocks Waver After Latest past year, the firm has seen the assets under its
Economic Data seven exchange-traded funds explode by more
than tenfold, from $3.2 billion at the end of 2019
Biden Administration Sets to a whopping $34.5 billion as of December. The
Out Detailed Plan for Virus
growth is partially due to ARK funds’ strong
Battle
performance in 2020, but also to surging interest
Chinese Telecom Companies from investors, who are pouring billions of dollars
Ask NYSE to Reverse Delisting of new cash into ARK products. Only six years
Plan since it was founded, ARK is now a top-10 fund
issuer in the U.S.

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Supercharged
ARK Investment has seen assets under its seven ETFs grow by more than tenfold in
2020.

ARKQ
$30.billion ARKF
ARKG

20

ARKK
10

IZRL
ARKW
0
PRNT
2019 '20
Source: Morningstar

While it’s generally a good thing when a fund is successful in growing assets, it
also means the fund needs to put all that new cash to work by buying more shares
of companies. In some cases, if the fund has a concentrated portfolio or invests in
the smaller companies, it can quickly bump up its stake in certain stocks.

That can be a problem from a liquidity and risk-management perspective. When a

favored stock stops being favored, for example, it could be difficult to quickly
reduce or exit the position if there are few buyers on the other side of the trade. It
can be costly to sell, and other investors might notice the selling and try to front-run
the trade or even short the stock, in a bet that it will drop.

ARK’s Capacity Challenge

Following its huge success, ARK seems to meet all the criteria for bumping up
against these challenges. Its asset size has grown tremendously; its actively
managed ETFs have concentrated portfolios, often holding fewer than 50 stocks;
and it often invests in the smaller, up-and-coming stocks for their growth potential.
The latest cash influx has pushed ARK to purchase more of its favored stocks. For
some smaller companies, ARK is now one of their largest outsider shareholders.

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According to Barron’s analysis, as of last Friday, ARK owns more than 10% of the
free float––shares that can be publicly traded without restriction––in at least 26
companies, most of which are biotech or tech firms. “Anytime you see any fund that
has such significant stakes in such a large number of firms, capacity becomes a
concern,” says Ben Johnson, director of global ETF research for Morningstar.

Major Shareholder
As its assets grow, ARK has become a major shareholder of many small companies it
invests in.
% of ARK ownership in free float
0% 5 10 15 20 25 30 35
AquaBounty Technologies
Personalis
Nano Dimension
Syros Pharmaceuticals
Pluristem Therapeutics
Compugen
Organovo
Intellia Therapeutics
Stratasys
Seres Therapeutics
Note: Data as of Jan. 15, 2021
Source: ARK Investment, FactSet

For AquaBounty Technologies (ticker: AQB), a biotech firm with a $595 million
market value, for instance, the ARK Genomic Revolution ETF (ARKG) owns nearly
30% of the company’s free-float shares. Even at larger firms like Crispr Therapeutics
(CRSP), with a market value of $14 billion, two of the ARK funds combined––with
about 5% weight in the stock––hold more than 15% of the company’s free-float
shares.

ARK declined to comment.

The increasingly large stakes in certain companies could also affect the efficacy of
a fund’s strategies going forward, says Johnson. “If the team continues to add the
same names that are their best ideas, investors should ask whether they are still an
attractive place to invest the new capital after prices have gone up so much.”

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An Old Problem for a New Company

To be sure, this problem is neither unique to ARK, nor new to the asset
management industry. Many mutual fund giants, such as Fidelity and T. Rowe
Price, have been dealing with capacity challenges for years as their popular
products become too large to manage. Many times they’ll simply cap a fund’s size
and close it to new investors. But that isn’t an option for ARK, since ETFs can’t be
closed like mutual funds.

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Funds & ETFs

That’s what makes ARK’s case special, and one of the first of its kind. Most ETFs––
especially those with huge assets under management––are diversified index funds
holding hundreds, if not thousands, of stocks. Each stock makes up a relatively
small percentage of the portfolio, and therefore doesn’t cause much of a capacity
problem even as the fund attracts more assets. Some ETFs have more
concentrated holdings, but they either focus on large-cap stocks––where liquidity
is abundant––or just don’t have enough assets to warrant capacity concerns.

ARK funds are the first concentrated, actively managed stock ETFs that have grown
to such large sizes. Not being able to curb the incoming cash flows, “the ball is in
ARK’s court to handle this problem as they see fit,” says Todd Rosenbluth, senior
director of ETF and Mutual Fund Research at CFRA.

How to Manage Capacity

What happened in 2017 to the VanEck Junior Gold Miners ETF (GDXJ) could offer
a good case study for what ARK can do. As investors got excited over the rebound
in gold prices, the fund attracted an enormous amount of new money and ended
up owning significant stakes in many small gold miners. To manage capacity, the
ETF started buying stocks and funds outside of its index constituents, and
eventually expanded the underlying index to allow the larger gold miners into its
portfolio.

ARK has more flexibility, since its ETFs are actively managed and therefore not
bound by an index. The company can increase the number of holdings in its
portfolios to dilute the weight in each stock, deploying some of the new capital to

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“next-best ideas” that the ARK funds don’t already have significant stakes in yet.
“They can own certain stocks that are not their highest favored ones, but still
favorable within that investment theme,” says Rosenbluth.

In addition, the ARK funds can gradually wind down their exposure to some of the
smaller stocks, while building larger positions in the highly liquid large-cap ones.
Trading data suggest the firm is already doing so.

In the first two weeks of 2021, ARK bought more shares of some larger companies.
As of Friday, it has $36 million invested in Lockheed Martin (LMT) and $133 million
in Bristol Myers Squibb (BMY), and nearly all of that was bought within the prior
week. Other highly liquid stocks, such as Baidu (BIDU), Zoom Video
Communications (ZM), and Nvidia (NVDA), have also seen their share in ARK funds
increase by more than 30% in just two weeks.

At the same time, ARK sold thousands of shares in some of the stocks where it has
the highest stakes. For example, it reduced its stake in ExOne (XONE) by 26%,
Organovo Holdings (ONVO) by 12%, and Pacific Biosciences of California (PACB)
by 6%. Still, even after the unload, ARK owns more than 10% of these firms’ free float
as of last Friday.

Risks and Constraints

To be sure, these trading actions aren’t necessarily driven by capacity concerns or
liquidity needs. ARK could be buying simply because it favors a stock’s future
return potential. The selling, on the other hand, could be a rebalancing move to
harvest gains. ARK declined to comment on the reasons behind its latest trading.

Still, moves like this bring potential risks. Following ARK’s huge success, market
participants have been closely watching the asset manager’s every move. Last
week, when ARK filed for a new space-exploration ETF, many space stocks jumped
by double digits in response to the headline, even though the new fund’s holdings
haven’t been disclosed.

“There is this degree of reflexivity almost,” says Johnson. “If the ARK team casts its
gaze on a particular name, just by the virtue of doing so, the share prices might
respond. Today they responded favorably. If this is in any way symmetrical, the
market may respond equally disfavorably if they sour on a particular stock,
especially if investors start to pull their capital.”
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So far it hasn’t been an issue. The three stocks mentioned above that ARK has been
selling, for example, continue to rise sharply as other investors take up the baton.
But further unloading could be interpreted as a bearish signal and trigger more
selling, and that could limit ARK’s ability to lock in some of its gains.

Further down the line, capacity constraints also mean that ARK won’t be able to
buy as many of its favored stocks as it would like to. That could be a drag on
performance, as well.

Write to Evie Liu at evie.liu@barrons.com

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