Morningstar has downgraded its stance on Cathie Wood’s flagship Ark Innovation ETF (ARKK) from ‘neutral’ to ‘negative’, citing potential over-concentration and liquidity risks going forwards.
In a note, Morningstar analyst Robby Greengold said ARKK suffered a “wretched” loss of 45.5% over the past 12 months, as at February.
Not only was this significantly greater than the average 7.9% loss booked by Morningstar’s broader tech fund category over the same period but worryingly, Greengold said the ETF “shows few signs of improving its risk management or ability to successfully navigate the challenging territory it explores”.
He continued, stating ARK Investment Management’s founder and CEO Wood (pictured) has “doubled down on her perilous approach” by almost halving the size of ARKK’s basket from 60 constituents less than a year ago to 35. Greengold argued this amplifies both the ETF’s stock-specific risk and its aggregate exposure to companies in which its parent company owns large stakes.
“The strategy has effectively become less liquid and more vulnerable to severe losses,” Greengold warned.
“Wood runs a variety of ETFs that often make shared bets on stocks and cannot close to new investors – an option open-end mutual fund rivals can use to preserve their liquidity and investment opportunity set. The firm has no risk-management personnel.”
However, these are hardly new complaints. When ARKK’s portfolio comprised 55 stocks, Morningstar data showed the ETF owned at least 5% of the publicly traded stock in more than a third of its constituents and at least 10% of the free float in 10 of the companies in its portfolio. At such elevated levels of ownership, there is a real risk that changes in ETF assets become a driver of the performance of underlying stocks.
While ARKK’s assets under management (AUM) have fallen by approximately half since last June, most of this owes to valuation decreases in its underlying investments, with investor redemptions making up only $1.8bn of the ETF’s AUM decrease over the past 12 months.
In turn, ARKK’s ownership in its underlying has not diminished greatly while its managers have almost halved the size of its basket, meaning it now spreads its money across fewer companies – many of which ARK holds in its other strategies.
Greengold is also right to raise the issue of liquidity. When BlackRock’s two clean energy ETFs held around $12bn and some oversized stakes across their 30-stock basket last year, Société Générale predicted the process of implementing changes to their underlying index during rebalancing would take as long as 48 days, based on the average daily trading volume of some small-cap stocks held by the ETFs – and how much of each stock would have to be sold.
While ARKK is an active stock-picking strategy that can be more agile with its trading than most rules-based ETFs, the issue of liquidity becomes more pressing, the more concentrated its portfolio gets.
“Wood’s reliance on her instincts to construct the portfolio is a liability,” Greengold continued. “This is a high-risk, benchmark-agnostic portfolio that invests across technology platforms the team thinks will revolutionize how sectors across the globe operate.
“The firm favours companies that are often unprofitable and whose stock prices are highly correlated. Rather than gauge the portfolio’s aggregate risk exposures and simulate their effects during a variety of market conditions, the firm uses its past as a guide to the future and views risk almost exclusively through the lens of its bottom-up research into individual companies.”
He concluded by pointing to ARK’s “poor succession plan”. Should lone portfolio manager Cathie Wood need to be replaced, it would currently fall to the firm’s director of research Brett Winton to fill the role. Not only does Winton have no experience as a manager but Greengold argued ARK has “an inability to develop and retain talent”, with many of its analysts having come and gone.
Morningstar is hardly the first to highlight the imperfections in ARK’s headline ETF. Last year, celebrity hedge fund manager Michael Burry took out short positions against ARKK and specific products launched in Europe and the US enable investors to go short on the ETF.
ARK Invest was approached for comment.