ARK Funds Could Become A Victim Of Their Own Success, ETF Expert Balchunas Says

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by Tyler Durden
Wednesday, Dec 23, 2020 - 02:20 PM

There have been few "success stories" created as a result of both the Fed and Softbank goosing the NASDAQ over the last 24 months quite as notable as Cathie Wood at ARK Invest. 

In addition to the ongoing power struggle at Wood's company, its ARKK Innovation ETF just passed JP Morgan "for the largest actively managed exchange-traded fund." The company's Innovation ETF now has over $18 billion in assets and on Wednesday, Bloomberg reported that ARK now owned more than 10% of 15 different stocks.

Additionally, Bloomberg's Eric Balchunas put out a great piece on Wednesday describing how the ARKK ETF could actually become a victim of its own success if cash continues to come in at the rate with which it has stacked up the last few years. As Charlie Bilello noted on Twitter, over the last month, it is currently seeing inflows of about $400 million per day.

Balchunas notes the ETF could have capacity issues due to it taking "in more in the past two weeks than in its first five years". ETFs don't have the option of closing, like mutual funds do, if they become to big. He notes that ARKK's $18 billion could "make it difficult to move in and out of smaller stocks".

"This one ETF has more in assets than the other 240 actively managed equity ETFs combined," he points out.

He also notes that the fund is naturally going to have to morph into a large-cap fund. "ARKK has shown a notable shift away from smaller companies and toward larger ones this year," he writes, claiming the firm's "bulging assets" are likely the reason.

ARK's large cap exposure has jumped 10% to 77% of its portfolio this year, while small cap exposure has gone to "almost nothing" from its previous 13%. The number of small cap investments has also been cut in half, coinciding with the firms "massive" inflows. 

The company now owns substantial portions of other companies, as noted above. It holds 10% of the float of 15 companies - including 12% of PagerDuty - which it only owned 3% of at the beginning of the year. 

"At $50 billion in assets, a 2% allocation to a typical small-cap company would translate to about 40% ownership," Balchunas writes. 

Balchunas predicts that unless there is a market correction, inflows will continue. The ETF, which traded $2 billion in volume earlier this week, is trading about 44x more than it averaged this spring. He calls ARKK the "biggest craze" since the DXJ - the currency hedged ETF that saw its outperformance turn to underperformance before losing "almost all of its $19 billion in assets". 

The note also points out that ARKK charges about 3x the average ETF at 75 bps. It also says that the ETF is 6th in potential fee revenue versus being 69th in assets. 

Recall, last week we noted that Cathie Wood would likely maintain control of ARK. Last month, the news broke that she was at risk of losing control due to Resolute Investment Managers exercising a call option from years prior that would make it majority owner of the business. 

We noted that back in November, ARK was delivered notice from Resolute Management Investors that they would be taking control of her firm due to an option in a deal Wood had negotiated back in 2016. The power shift, which Pensions & Investments noted last month wasn't especially amicable, came due to a 2016 agreement between Resolute and ARK, where RIM acquired a minority stake in the investment manager - with a call option "to purchase a controlling voting and equity interest in (ARK) that is exercisable in 2021."

At the time the intent to exercise was announced, Wood had said: "On behalf of the employee-owners of ARK, we are disappointed that Resolute Investment Managers and its private equity owner, Kelso & Co., have chosen to issue this unwelcome notice that they intend to seize control of our business."

In speaking to Bloomberg last week about the potential power shift, Wood said: “That has quieted down and we are in negotiations, We wanted to be fair and square with our partner, and I think things will work out.”