Are Cathie Wood's ARK Invest funds over exposed to some small caps?

By Kirsteen Mackay

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Cathie Wood's ARK Invest funds are experiencing outflow. It's doubling down for now, but could this unravel its phenomenal success?

Passive investing via ETFs has exploded in popularity in recent years. It’s hands off investing for time-starved consumers. Theoretically it should reduce risk, and it’s often much cheaper than buying individual stocks. Last year Cathie Wood’s ARK Invest funds did phenomenally well, but is this set to continue?

In recent years, fee-free trading platforms like Robinhood have entirely changed the investing landscape. Now that retail investors can buy fractional shares, starting with as little as a dollar it means more people than ever before have been discovering the world of stock market investing. This has proven both good and bad for listed companies.

It means retailers are taking more interest in stock market investing in general, whether than be buying shares directly or via an ETF.

ARK Invest: Inflows and outflows

The Covid-19 pandemic accelerated this shift in financial awareness to epic proportions and 2020 saw ARK Invest’s popularity soar.

Inflows into ARKs ETFs climbed an astronomical 1000% in 2020 from $3.1 billion to $34.5 billion.

Cathie Wood made herself accessible with regular video updates. She posts ARK’s ETF holdings daily and she has been regularly interviewed across many platforms to discuss her stock picks. This keeps investors interested, either in the ARK funds they hold, or in copy-cat investing in the individual stocks Wood’s funds contain.

Wood’s popularity has also soared because she’s been so steadfastly bullish on tech stocks across the board from Tesla and Shopify to tiny biotech’s like Cerus Corp and even SPAC’s like Butterfly Network.

Stock Market Correction – Photographer: Maxim Hopman | Source: Unsplash

However, it appears the recent tech stock correction is rapidly unravelling her success. ARK’s funds collectively lost more than $1.8 billion between February 24 and March 1. According to FactSet, this their biggest stretch of outflows ever.

But she’s standing strong in her conviction, even selling off big name tech stocks to throw more money at the falling knives. And video footage of her this week shows her as calm and self-assured as ever.

Disruptive innovation

ARK is known for its disruptive innovation approach to stock picking. It has specific themes it’s looking to invest broadly in. These include Genomics, Fintech, Artificial Intelligence and soon to be Aerospace. Technology is at the crux of ARKs vision and the types of companies that can innovate in a way that will disrupt life as we know it for the better. Many of these exist under the spatial computing umbrella.

The vision is compelling and steers investors on an intriguing path to an exciting future. Cathie Wood also has previous successes to back up her persuasive belief. She was an early investor in Amazon when other investment firms wouldn’t touch it with a barge pole. And she’s been a Tesla bull long before anyone saw any significant value in the company.

Nikko Asset Management, is a Japanese firm with a minority stake in ARK Invest. And ARK consults for them. Together they own more than 25% of three businesses they’re invested in:

  • Compugen Ltd (NASDAQ:CGEN) 29.1%

  • Organovo Holdings Inc (NASDAQ:ONVO) 26.4%

  • Intellia Therapeutics Inc (NASDAQ:NTLA) 25.3%

And combined ARK and Nikko own 20% or more of an additional 10 companies.

Why is this a problem?

Nikko also runs a collection of funds and several of its products follow the same investment thesis as ARK. With both investing in the same small specialist companies, this could unintentionally put the companies at risk.

These lesser-known stocks often have poor liquidity, so a mass outflow of funds from ARK or Nikko could force it to sell positions. This could cause severe volatility in the price of these less-liquid stocks. In turn, creating a knock-on effect, making direct shareholders panic sell, causing even more damage to the underlying share price.

Short targets

There is also the implied risk that these less-liquid companies could be at increased risk of becoming short targets.

There’s been a trend showing that companies ARK owns a high percentage share in, also present a higher-than-average short interest. But it’s impossible to confirm whether that’s because ARK is the concern driving the short seller, or simply the stock is a riskier bet in the first place, thereby encouraging short interest.

When Bloomberg asked ARK and Nikko to comment on their combined concentration risk, neither provided a response.

Transparency: A double edged sword

ARK’s transparency is its competitive advantage because it helps educate people. It’s convincing and gets them excited about the next big thing in the market.

Investors are always looking for reassurance and ARK’s transparency gives this to them, making them extremely grateful.

However, the fund’s transparency could also be its undoing. The recent Reddit fuelled short squeeze targets have been chosen when they discover companies with a large short presence and using the power of the crowd, aim to push the shorts out. It’s powerful to a point, but it causes extreme volatility in the stock and potentially undermines its strength as a viable business.

A perfect storm brewing

Arguably, its transparency could be the reason ARK Invest has reached its insane level of success. But this transparency gives hedge funds and investors an edge because they know exactly the moves its making and its levels of liquidity. A perfect storm of Reddit short squeezes and economic uncertainty could be enough to unravel the entire business.

Whether shareholders exit ARKs ETFs directly or sell the underlying stocks, this will result in ARK losing liquidity. Now, it’s a highly liquid whale, but any losses in liquidity force it to sell more and more. At the moment it’s selling out the big fish and doubling down on the minnows, but that can only last so long.

It’s not a given that this scenario will play out but remains a potential threat to watch out for. Many ARK investors have made a lot of money in this past year and seeing the returns pull back could be the catalyst to cash in.

Interest rates rising could also send investors to safer havens than tech stocks underpinned by low interest rates. ARK’s funds are not defensive in nature, and in economic turbulence investors may look for something safer.

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Topics:
Cathie Wood
Ark Invest

Author: Kirsteen Mackay

This article does not provide any financial advice and is not a recommendation to deal in any securities or product. Investments may fall in value and an investor may lose some or all of their investment. Past performance is not an indicator of future performance.

Digitonic Ltd, the owner of ValueTheMarkets.com, does not hold a position or positions in the stock(s) and/or financial instrument(s) mentioned in the above article.

Digitonic Ltd, the owner of ValueTheMarkets.com, has not been paid for the production of this piece by the company or companies mentioned above.