ARK Investment was one of the fastest-growing fund managers in 2020. Now it might be facing a problem due to its exponential growth: The company owns too much of some companies it invests in, which could limit its ability to select and trade stocks freely.

Led by CEO and founder Cathie Wood, ARK specializes in investments in disruptive innovations. Over the past year, the firm has seen the assets under its seven exchange-traded funds explode by more than tenfold, from $3.2 billion at the end of 2019 to a whopping $34.5 billion as of December. The growth is partially due to ARK funds’ strong performance in 2020, but also to surging interest from investors, who are pouring billions of dollars of new cash into ARK products. Only six years since it was founded, ARK is now a top-10 fund issuer in the U.S.

While it’s generally a good thing when a fund is successful in growing assets, it also means the fund needs to put all that new cash to work by buying more shares of companies. In some cases, if the fund has a concentrated portfolio or invests in the smaller companies, it can quickly bump up its stake in certain stocks.

That can be a problem from a liquidity and risk-management perspective. When a favored stock stops being favored, for example, it could be difficult to quickly reduce or exit the position if there are few buyers on the other side of the trade. It can be costly to sell, and other investors might notice the selling and try to front-run the trade or even short the stock, in a bet that it will drop.

ARK’s Capacity Challenge

Following its huge success, ARK seems to meet all the criteria for bumping up against these challenges. Its asset size has grown tremendously; its actively managed ETFs have concentrated portfolios, often holding fewer than 50 stocks; and it often invests in the smaller, up-and-coming stocks for their growth potential. The latest cash influx has pushed ARK to purchase more of its favored stocks. For some smaller companies, ARK is now one of their largest outsider shareholders.

According to Barron’s analysis, as of last Friday, ARK owns more than 10% of the free float––shares that can be publicly traded without restriction––in at least 26 companies, most of which are biotech or tech firms. “Anytime you see any fund that has such significant stakes in such a large number of firms, capacity becomes a concern,” says Ben Johnson, director of global ETF research for Morningstar.

For

AquaBounty Technologies

(ticker: AQB), a biotech firm with a $595 million market value, for instance, the

ARK Genomic Revolution

ETF (ARKG) owns nearly 30% of the company’s free-float shares. Even at larger firms like

Crispr Therapeutics

(CRSP), with a market value of $14 billion, two of the ARK funds combined––with about 5% weight in the stock––hold more than 15% of the company’s free-float shares.

ARK declined to comment.

The increasingly large stakes in certain companies could also affect the efficacy of a fund’s strategies going forward, says Johnson. “If the team continues to add the same names that are their best ideas, investors should ask whether they are still an attractive place to invest the new capital after prices have gone up so much.”

An Old Problem for a New Company

To be sure, this problem is neither unique to ARK, nor new to the asset management industry. Many mutual fund giants, such as Fidelity and T. Rowe Price, have been dealing with capacity challenges for years as their popular products become too large to manage. Many times they’ll simply cap a fund’s size and close it to new investors. But that isn’t an option for ARK, since ETFs can’t be closed like mutual funds.

That’s what makes ARK’s case special, and one of the first of its kind. Most ETFs––especially those with huge assets under management––are diversified index funds holding hundreds, if not thousands, of stocks. Each stock makes up a relatively small percentage of the portfolio, and therefore doesn’t cause much of a capacity problem even as the fund attracts more assets. Some ETFs have more concentrated holdings, but they either focus on large-cap stocks––where liquidity is abundant––or just don’t have enough assets to warrant capacity concerns.

ARK funds are the first concentrated, actively managed stock ETFs that have grown to such large sizes. Not being able to curb the incoming cash flows, “the ball is in ARK’s court to handle this problem as they see fit,” says Todd Rosenbluth, senior director of ETF and Mutual Fund Research at CFRA.

How to Manage Capacity

What happened in 2017 to the

VanEck Junior Gold Miners

ETF (GDXJ) could offer a good case study for what ARK can do. As investors got excited over the rebound in gold prices, the fund attracted an enormous amount of new money and ended up owning significant stakes in many small gold miners. To manage capacity, the ETF started buying stocks and funds outside of its index constituents, and eventually expanded the underlying index to allow the larger gold miners into its portfolio.

ARK has more flexibility, since its ETFs are actively managed and therefore not bound by an index. The company can increase the number of holdings in its portfolios to dilute the weight in each stock, deploying some of the new capital to “next-best ideas” that the ARK funds don’t already have significant stakes in yet. “They can own certain stocks that are not their highest favored ones, but still favorable within that investment theme,” says Rosenbluth.

In addition, the ARK funds can gradually wind down their exposure to some of the smaller stocks, while building larger positions in the highly liquid large-cap ones. Trading data suggest the firm is already doing so.

In the first two weeks of 2021, ARK bought more shares of some larger companies. As of Friday, it has $36 million invested in

Lockheed Martin

(LMT) and $133 million in

Bristol Myers Squibb

(BMY), and nearly all of that was bought within the prior week. Other highly liquid stocks, such as

Baidu

(BIDU),

Zoom Video Communications

(ZM), and

Nvidia

(NVDA), have also seen their share in ARK funds increase by more than 30% in just two weeks.

At the same time, ARK sold thousands of shares in some of the stocks where it has the highest stakes. For example, it reduced its stake in

ExOne

(XONE) by 26%,

Organovo Holdings

(ONVO) by 12%, and

Pacific Biosciences of California

(PACB) by 6%. Still, even after the unload, ARK owns more than 10% of these firms’ free float as of last Friday.

Risks and Constraints

To be sure, these trading actions aren’t necessarily driven by capacity concerns or liquidity needs. ARK could be buying simply because it favors a stock’s future return potential. The selling, on the other hand, could be a rebalancing move to harvest gains. ARK declined to comment on the reasons behind its latest trading.

Still, moves like this bring potential risks. Following ARK’s huge success, market participants have been closely watching the asset manager’s every move. Last week, when ARK filed for a new space-exploration ETF, many space stocks jumped by double digits in response to the headline, even though the new fund’s holdings haven’t been disclosed.

“There is this degree of reflexivity almost,” says Johnson. “If the ARK team casts its gaze on a particular name, just by the virtue of doing so, the share prices might respond. Today they responded favorably. If this is in any way symmetrical, the market may respond equally disfavorably if they sour on a particular stock, especially if investors start to pull their capital.”

So far it hasn’t been an issue. The three stocks mentioned above that ARK has been selling, for example, continue to rise sharply as other investors take up the baton. But further unloading could be interpreted as a bearish signal and trigger more selling, and that could limit ARK’s ability to lock in some of its gains.

Further down the line, capacity constraints also mean that ARK won’t be able to buy as many of its favored stocks as it would like to. That could be a drag on performance, as well.

Write to Evie Liu at [email protected]



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