ARK Invest’s Strong Appetite for Risk

Today’s young tech investors don’t seem to care much about risk. If they did, they’d first need to define risk. For any given portfolio of stocks, a common risk is correlated returns (when stocks move together in the same direction). This is why diversification is such an important concept.

If you’re invested in one stock, you’re overdosing on company-specific risk. If you’re only invested in small caps, that’s a size bet which increases risk. If you only buy U.S. stocks, you’re exposed to single country and currency risk. If you only buy healthcare stocks, that’s an industry exposure risk. And if your stocks move together as a group even if they’re not in the same industry – gene editing stocks and 3D printing stocks are two good examples – then that’s a risk that’s not so obvious.

Risk can also be defined as “the volatility of returns.” When there are external factors increasing volatility, we need to evaluate them. One risk factor that’s increasing our portfolio volatility is “the ARK effect.”

What is the ARK Effect?

“The ARK effect” is simply the extent to which ARK Invest – the leading thematic fund manager – influences the price of certain disruptive technology stocks. Their success story has become a double-edged sword. As ARK’s assets under management (AUM) soared, they were forced to acquire more and more shares of the companies they hold in a very short time frame.

Credit: Bloomberg

As a result, they’re holding an abnormally large percentage of certain companies. This presents a problem if they need to sell their shares quickly based on the principles of supply and demand. Just look at this incredibly thoughtful table CNBC put together yesterday to demonstrate ARK’s concentration problem:

This is what happens when you don’t hire based on competency – Credit: CNBC

If you’re holding shares of Statasys (SSYS) or Photo Labs (PRLB), you ought to be concerned. Why? Because when ARK suddenly needs to sell shares in these companies, they’ll drive the price through the floor. When they need to buy more shares, they’ll send the price through the roof. In other words, the ARK effect is what happens when a large successful fund manager is restricted to a small universe of stocks. The result is an increase in volatility for many of their largest holdings that are more correlated than not. What complicates things even more is how ARK’s ETFs overlap, something we discussed in our recent piece on ARK’s Space ETF. For example, three of their top five actively managed ETFs hold 10% or more of Tesla.

In the below table we’ve taken ARK Invest’s five largest actively managed ETFs (representing nearly $40 billion in AUM) and listed out the top-15 holdings according to ETFdb.com. We then marked all duplicate stocks – stocks that exist in two ETFs are in yellow, while pink designates stocks held in three ETFs or more:

Tesla probably has the liquidity to support ARK suddenly selling a boatload of shares, but other companies may not. Selfishly, we’re just concerned with knowing how much exposure our disruptive tech stock portfolio has to “the ARK effect.” We’ll keep things simple. What is the total weighting in our own portfolio of all stocks seen in the above table? Turns out we’re holding seven of them for a combined weighting of 10.7%. (Nanalyze Premium annual subscribers will know which ones.) So, what sort of risk does that exposure represent? The answer might surprise you.

The ARK Effect Goes Both Ways

As ARK quickly moved to accumulate this concentrated list of stocks, that would have driven prices upwards – (demand outpaces supply). As a result, some investors may have overpaid for their shares. When investors move out of ARK’s funds and they need to sell shares, prices could plummet – (supply outpaces demand). Since this gives us an opportunity to buy assets at a cheaper price, it means we actually want to hold quality companies that may be impacted by the ARK effect. In either scenario, volatility increases along with risk. Since ARK predominantly operates actively managed funds (they don’t track benchmarks), things can become quite complicated very quickly. It’s just one of many criticisms being raised by financial pundits.

Out Come the Critics

When you’re successful, you’re bound to have critics. As ARK Invest’s ETF returns float slowly back down to earth, plenty of people are there to point out their shortcomings. One such critic is a strategist from Morningstar who published a piece a few months back in which he gives ARK a proper dressing down.

Credit: Morningstar

You can tell this gentleman is an ambitious go-getter because he wasted invested 3 years of his life studying after work to achieve the coveted Chartered Financial Analyst (CFA) designation. He also has an MBA, but fortunately didn’t include those letters. (People who put “MBA” after their name are of the same ilk as those who did a PhD in gender studies and refer to themselves as “Dr.”) And we’re only giving him grief because he criticized ARK’s analysts saying, “almost none of ARK’s analysts have progress beyond earning bachelor’s degrees.” To be fair, he may be on to something. Exhibit A:

MBAs don’t use Twitter to communicate, they use secretaries – Credit: Twitter and Yahoo Finance

When an ARK analyst asked on Twitter to speak to the Bionano Genomics CEO, shares of the stock went through the roof days later. Coincidence? Maybe, but if this lad thinks that speaking to a company CEO is a viable way to assess the merits of a stock, he’s in for a big surprise. Perhaps that’s why ARK invested in names like Organovo and Nano Dimension, two companies that are more lost than a deaf bloke playing bingo. Said ARK Invest yesterday:

Credit: ARK Invest Stock Commentary

Yes, we’d all like to know more about Organovo’s plans considering they’ve done eff all since we began asking “where are the revenues?” six years ago. At least they’re not as bad as Nano Dimension, a $1.82 billion company with Q1-2021 revenues of $811,000. Using our simple valuation ratio – market cap / annualized revenues – we get the highest valuation ratio we’ve ever seen for a disruptive tech stock – 561.

The Morningstar article talks a lot about ARK’s appetite for risk and – at least according to the author – an unwillingness to manage it by employing risk management professionals to stress-test some scenarios. (Given ARK Invest’s relationship with MSCI, it’s hard to believe they haven’t been sold a risk management solution yet.) Says the Morningstar piece:

The portfolio of its flagship strategy, ARK Innovation, is top-heavy, makes huge industry bets, and has historically invested in publicly traded companies of virtually every size. It embraces money-losing companies so long as they’re aggressively investing to exceed their already high growth expectations.

ARK doesn’t have a market cap cutoff, so they’ll invest in small companies and treat them with the same attention as large ones (Organovo has a $67 million market cap). They also invest in pre-revenue companies, something we strongly advise against. When it comes to geographic location, ARK explicitly states their domestic bias, opting for predominantly U.S.-traded stocks in their portfolios. So far, their strategy has worked out quite well, but volatility goes both ways.

When tech investors stop caring about risk, bubbles are born. ARK argues that they’re invested in “deep value” stocks which have been overlooked and underpriced. Their bullish stance on bitcoin epitomizes their desire to invest in what might happen tomorrow vs. what’s happening today. ARK’s Midas touch means whatever stocks they invest in become self-fulfilling prophecies as traders move quickly to trade off those signals. But hype and tons of capital will only take a company so far unless they can produce an economically viable product or service that generates meaningful revenue growth.

The takeaway for disruptive tech investors is simple. If you’re invested in a stock that ARK is holding a large position in, it better be one you’re comfortable buying at a much cheaper price.

Conclusion

ARK Invest is increasing the volatility of stocks they buy and sell – the ARK effect. To offset risk from the ARK effect, we sold their flagship ETF and used the money to buy other assets that aren’t being held by ARK, and likely never will be (a cybersecurity ETF and a battery stock). If you’re a disruptive tech stock investor, now is a good time to evaluate your exposure to ARK’s top holdings, something that’s not necessarily a bad thing if they happen to be quality companies.

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