By every measure, the ARK family of funds has been tremendously successful. ARK founder Cathie Wood and team have seen their vision of the trends that will shape the future translate into off-the-charts performance. Investors have taken notice, and investment flows have followed. The firm’s recent growth is unprecedented among the upper ranks of the asset management industry. But as the firm skyrockets up the industry league table, investors should be asking whether the kind of performance that has landed ARK on its current perch is sustainable—especially as capacity concerns mount.

ARK’s arc

From its Oct. 31, 2014, inception through Feb. 28, 2021, ARK’s flagship fund, the ARK Innovation ETF (ARKK) gained 36.01 per cent on an annualised basis. That is nearly 23 percentage points better than the Morningstar U.S. Market Index and just over 21 percentage points ahead of the mid-cap growth Morningstar Category average. In 2020, ARKK’s performance went from peppy to parabolic as the fund gained 153 per cent. A US$10,000 investment at inception would have been worth US$70,053 on Feb. 28, 2021.

Chart of ARK fund compared to market

ARKK’s since-inception performance puts it in rarefied air. Only 64 of the 8,637 (0.74 per cent) U.S.-domiciled stock mutual funds in Morningstar’s U.S funds database have ever gained as much or more over a similar time frame. The common thread among most of these highfliers is the fact that they rode booming markets to great gains. Of the 64 funds in this exclusive group, 26 (40 per cent) trace their success to the inflating of the dot-com bubble, which took some of them with it when it burst. Included in that group of 26 is a fund that today goes by the name AB Sustainable Global Thematic, which ARK founder Cathie Wood ran from 2009-13. Many of these funds ultimately folded. Of the 64 on this list, 14 (21 per cent) have since been liquidated. Some merged into other offerings. And others have seen regular changes in management—most notably Fidelity Magellan (FMAG), which gained nearly 43 per cent annually from March 1977 through June 1983 with Peter Lynch at the helm. In all cases, searing returns cooled off after a hot streak. A majority of these funds’ subsequent returns were negative over the ensuing three- and five-year periods.

History of fund performance
Fund history of AUM

This level of growth has no precedent among the upper ranks of the asset management industry. During the year ended January 2021, the organic growth rate of ARK’s U.S. exchange-traded fund lineup was 886 per cent. This was several times faster than the fastest organic growth rates ever posted by any of the other current 15 largest U.S. fund families.

Exponential growth of U.S. fund families

There is no denying ARK’s impressive trajectory. But is it sustainable? Historical precedents suggest it isn’t. And after a period of stellar returns and a flood of inflows, capacity concerns loom large.

Measuring and managing capacity

In the context of funds, capacity is the amount of money an investment strategy can take in without compromising its performance. Every investment strategy has a finite amount of capacity, the amount of which depends on a variety of factors. These include the breadth and depth of the investment opportunity set, liquidity, valuations, and more. A market-cap-weighted total U.S. stock market index fund has immense capacity. The U.S. stock market is broad, deep, and generally liquid. A market-cap-weighted index is valuation-agnostic. Investors can allocate trillions of dollars to market-cap-weighted U.S. stock funds without capacity becoming a concern--and they have. At the other extreme of the capacity continuum, one might find an actively managed portfolio of small-value stocks. This narrower corner of the market features fewer opportunities, less-liquid stocks, and valuation-sensitive managers. Small-cap value strategies can only take on so much money before bumping into capacity constraints.

Too often, asset managers dismiss as a “wouldn’t that be nice to have” problem. This is because accepting more money from investors has an immediate, positive impact on their bottom line. But failing to manage capacity prudently can be detrimental to their investors. Asset bloat can lead managers to stray from their mandates. New money they receive from investors may be added to existing positions in their portfolios that are no longer trading at attractive valuations or to new positions that represent managers’ next-best ideas. Too much money chasing too few good ideas at unattractive valuations is not a formula for successful investing.

There are ways that fund managers can either prevent or cope with capacity issues. They can focus on areas of the market that are broader, deeper, and more liquid—like U.S. large caps. They might ply a strategy that is style-indifferent—spanning value and growth stocks, for example. But the simplest and most effective means of nipping capacity issues in the bud is to simply say “no” to new money. This can take the form of locking out new investors (that is, a “soft” close) or both new and existing ones (that is, a “hard” close). It is a practice that is quite common in small- and mid-cap funds that have produced strong performance.

Closing a fund can be a difficult decision for asset managers to make. It is at odds with their business objectives. More assets mean more fees. That said, there are plenty of examples of firms that have long taken a thoughtful approach to capacity management and regularly closed their funds to the benefit of their shareholders. Virtually every successful active stock-picker has closed a fund at one time or another. Of course, there are also those that couldn’t say “no” to more assets and crumbled under their own weight—to the detriment of all involved.

Stretching at the seams

There are increasing signs that ARK’s funds are facing capacity challenges. This is evidenced by the changing contours of its flagship fund’s portfolio and the market impact of its trading activity.

The complexion of ARKK’s portfolio has changed. Over the five years from July 2015 through July 2020, the average market cap of companies within ARKK’s portfolio never topped US$10.5 billion, consistent with the team’s goal of finding under-the-radar companies that the market doesn’t fully appreciate. Since then, the fund’s average market cap has spiked, topping US$20 billion in November 2020 and reaching over US$35 billion in January 2021.

Much of the increase in ARKK’s average market cap has owed to rapid price appreciation among many of the smaller companies in its portfolio. But as assets have swelled, ARK has also begun deploying cash in more-established large-cap companies, a shift that is further changing the makeup of the portfolio. From Oct. 31, 2020, through Jan. 31, 2021, the fund initiated new positions in 10 companies. All but three of these companies had market caps greater than US$30 billion at the time of purchase, and three—Novartis (NVS), PayPal (PYPL), and Baidu (BIDU)—are mega-caps with market caps of more than $100 billion. It appears the fund’s heft is at least partly responsible for pushing it toward owning larger names.

As its picks have posted big gains and it has added bigger names at the margin, small caps’ representation in ARKK’s portfolio has fallen. At the end of October 2020, 33 per cent of ARKK assets were in stocks with a market cap under $5 billion; by the end of February 2021, those stocks made up just 14 per cent of the fund. None of those stocks rose as a percentage of fund assets over that time period.

Even as ARK has shifted to established, larger-cap companies, it still maintains a sizable ownership stake in many of its smaller holdings. Looking across the portfolios of its five actively managed ETFs, we find that ARK owns more than 10% of 26 companies, up from 24 in October 2020. This data ignores the firm’s two passive ETFs, as well as the funds they subadvise for Japanese asset manager Nikko, which would push its stakes even higher. The firm has reduced some of its largest ownership stakes and increased others. The ARK team has no formal risk management policies in place with respect to its ownership levels in portfolio companies, but it is generally wary of being considered an affiliate of any issuer by the SEC. Per the SEC’s definition, an affiliate has “possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise.” So, ARK doesn’t want to put itself in a position where the SEC could question its level of involvement in the day-to-day business decisions of one of its holdings.

These large stakes raise concerns around capacity and liquidity management. The more of a company the firm owns, the more difficult it will be to add to or reduce its position without pushing prices against fund shareholders. For example, ARK holds approximately 25.8 million shares of Cerus (CERS)—a biotech company with a US$1 billion market capitalisation. Cerus’ shares represent 0.48 per cent of ARKK’s portfolio and 0.44 per cent of Ark Genomic Revolution (ARKG). In a liquidation scenario, assuming the firm accounted for 25 per cent of the past month’s average trading volume of 1.9 million shares a day (a generous amount that assumes near-perfect trading conditions), it would take more than 52 trading days for it to completely exit the position.

Days to liquidate names at 25% of volume

These ownership stakes tie ARK’s hands. If it changes its thesis on a company and wants to scale down quickly, it won’t be able to do so without materially impacting stock prices. It also increases the exogenous risks it faces related to the behavior of its investors. If the firm faces outflows that outpace its ability to sell these stocks, these illiquid positions could rise as a percentage of the funds’ assets, especially as the team has typically reduced its stake in “cashlike” stocks and added to its favorite names during sell-offs. Wood has used Taiwan Semiconductor (TSM) as an example of what the team considers a “cashlike” stock. Per her definition, these names generally have bigger market caps and greater liquidity and are “value” stocks with “tremendous call options.” In a scenario where outflows persist and these large, more-liquid stocks are the first to go, the funds’ holdings could become increasingly concentrated in less-liquid positions.

Stowaways

ARK is also beginning to have difficulty initiating positions in new names. Take Paccar (PCAR), a manufacturer of heavy-duty trucks, which ARK first added to ARKK on Jan. 20, 2021. On Jan. 19, Paccar announced a partnership with autonomous vehicle platform Aurora. The announcement likely piqued ARK’s interest but went little noticed by the market. That day, Paccar’s stock closed at US$89.21, up 1.19 per cent from its US$88.17 open. ARK purchased around 175,000 shares of Paccar on Jan. 20, about 16 per cent of the stock’s average daily trading volume of 1.1 million shares over the previous 20 trading sessions. ARKK’s new stake amounted to roughly 0.07 per cent of its portfolio. ARK broadcast its new stake after markets closed on Jan. 20. The next day, Paccar’s share price jumped 7 per cent at the open, on no news other than ARK’s disclosure from the night before. After its initial purchase, ARK added to the position on 10 of the next 11 trading days, building it up to about a 1 per cent position in the fund.

ARK influence on Paccar's price

This example illustrates two problems. The first is that because of ARK’s size, it might not be able to buy enough stock in one day to reach its desired position size. Had ARKK been a US$1 billion fund, it could have established a 1 per cent position in Paccar by purchasing a little more than 111,000 shares on Jan. 20, assuming an average price of US$90. Instead, it had to spread the purchase over multiple days, resulting in a higher average cost.

The second problem is that ARK’s newfound stardom means the market is watching—and sometimes copying--its every move. By simply initiating a new position, ARK can send a stock’s price soaring. Since the beginning of 2021, ARK has made 20 first-time buys across its five actively managed ETFs. Among those 20 new names, 14 saw their stock prices rise more than 3.5 per cent the day after ARK revealed its first purchase.

This has been a tailwind for the funds. It is a form of reflexivity. ARK buys a stock. The buying boosts the share price, which in turn boosts fund returns. A spike in the funds’ returns drives flows into the funds, which then spurs the fund to buy more shares and drive prices higher. However, this can just as easily work in reverse in a scenario where redemptions increase and/or returns disappoint.

Other stocks that have gotten a pop

In isolation, both these issues can be managed. But it is much more difficult when they arise in tandem. Portfolio managers regularly spread their trades over multiple days--especially when initiating new positions at a size that could move the market against them if they don’t tread carefully. And it is not uncommon for stocks to pop after the market learns a successful manager has taken a new position. The challenge for ARK is that prices have sometimes surged before the team has fully sized its positions. This is an artifact of executing a capacity-constrained strategy in a wrapper that only exacerbates capacity-related challenges.

Managing capacity in an ETF

ARK is facing a novel challenge in managing capacity. Of the US$53.2 billion that the firm manages in regulated funds, 96 per cent is invested in its ETFs. The ETF wrapper has many investor-friendly features. ETFs tend to offer lower costs and greater tax efficiency than mutual funds. By virtue of being traded on stock exchanges, ETFs are also more widely available at lower investment minimums (typically as low as the price of a single share). But when it comes to plying an active strategy with significant capacity constraints in an ETF, the drawbacks may outweigh the benefits.

As it pertains to capacity, the most significant drawback of the ETF wrapper is that managers cannot say “no” to new money. An ETF’s manager cannot suspend the creation of new shares at its discretion. Thus, the simplest and most effective means of addressing capacity concerns is not at their disposal. Instead, the firm must either:

  1. Allocate new money to existing positions that have experienced significant price appreciation.
  2. Invest in its next-best ideas.
  3. Some combination of number one and number two--which is what has happened to date.

Since the ETF can’t close to new investors, new assets will inevitably diminish the team’s ability to buy its best ideas at compelling valuations.

Another shortcoming of the ETF wrapper is that ARK’s U.S. ETFs must disclose their portfolios to the market each day. As the firm’s assets under management have mushroomed, so have the number of eyeballs watching its every move. In fact, there is a website and an app (ARK Tracker) that monitor the firm’s trades daily. Investors can also sign up for intraday trade alerts on the company’s website. While transparency is generally laudable, this degree of transparency has never been tested at ARK’s current scale. Based on the market’s response to many of its new positions in smaller names, it appears that this degree of visibility is impeding the team’s ability to build positions in new holdings without sometimes significantly impacting their prices. The daily transparency provided by the fully transparent active ETF format may be detrimental to shareholders.

Forfeiting the ability to turn down new investors and tipping its hand to the market each day are serious structural impediments to ARK’s ability to manage capacity in its ETF lineup. Similarly, because of the equitylike characteristics of ETFs, the firm can’t control where new investors are coming from or readily discern what their motives might be.

Demand for ETF shares can come from virtually anywhere and anyone that can trade on a stock exchange and legally own the shares. As such, ETFs are more widely available to a larger prospective investor base at lower investment minimum (typically the price of a single share) than traditional open-end mutual funds. For example, there is evidence of widespread demand for ARKK’s shares in the 13-F forms filed by the fund’s current institutional owners, which range from Morgan Stanley brokerage accounts to Chilean mutual funds.

But demand for ETF shares isn’t driven exclusively by traditional long-only, buy-and-hold investors, be they individuals, intermediaries, or institutions. As equity instruments, ETFs can also be sold short. Also, many ETFs have derivative contracts, such as call or put options, linked to them. Demand for shares of ARK’s ETFs can be driven by investors looking to bet against the ARK team or to hedge options dealers’ exposure. Indeed, in recent weeks, we’ve seen short interest in ARKK’s shares and open interest in options tied to the fund reach new highs. Demand from these atypical sources can put more capital on the ARK team’s plate.

While there are some precedents of the kind of performance that the ARK team has generated, its explosive growth and the fact that the majority of its assets are invested in fully transparent actively managed ETFs make it unique. While the ETF wrapper has many investor-friendly characteristics, in this instance, it might be investors’ enemy.

Think twice before climbing aboard

There is no denying that ARK has made a lot of money for a lot of investors in recent years. But if history is any guide, the billions of dollars that have flooded into these funds in the past year are unlikely to enjoy the same level of historical returns that attracted many new investors to them. Capacity issues, and the ARK team’s inability to manage them effectively in its ETF lineup, mean that it is even less likely that past will be prologue. If performance turns for the worst, money that has been quick to come may be quicker yet to go. The risk facing investors is that the same degree of reflexivity that has seemingly benefited them on the way up is likely to work against them on the way down. Ultimately, investors should think twice before boarding this ship, and if they do, it is important that they lower their expectations, as the seas ahead aren’t likely to be as fair as those behind.