In the late 2000s, when I was an equity research analyst at Lehman Brothers Holdings Inc., my manager would say, “To win big, you have to think small.” I worked with a team of math, finance and accounting wizards, many fresh out of graduate schools, to sift through the financials of thousands of small-cap companies, looking for some advantage or hidden pattern that the bank’s trading desks could use to make money.
That turned out to be a losing game.
Even if Lehman did not go bankrupt, our team — which hired dozens of people for the data-intensive work — would have been disbanded in a few years. That’s because in the ensuing decade, large-cap stocks would become by far the biggest winners. Between 2010 and 2019, the S&P 500 Index returned 256.7%, about 50 percentage points higher than the small-cap heavy Russell 2000 Index. And the lack of love for small-caps became most pronounced in 2019.
The culprit was passive investing. At the start of the last decade, roughly 20% of the money was managed passively. By 2019, inexpensive index funds and ETFs managed more money than active ones. As more household savings went into these vehicles — which often weight their stock portfolios by market value — big companies naturally got more of the money inflow, thereby furthering their returns.
Cathie Wood, and the rise of thematic ETFs, are now challenging the merit of passive investing, as well as lazy Nasdaq whales — large funds whose trade was simply riding the tide of Big Tech stocks. Thanks to Wood and retail investors suffering from lockdown-induced boredom, stock picking is back in fashion.
The ETFs that Wood’s ARK Investment Management offers are by no means passive. For her flagship Ark Innovation ETF, Wood does not weight her stock picks based on, say, market cap — a simple portfolio allocation methodology that can easily be automated by machines. Instead, she looks for smaller companies even as she retains Tesla Inc., a $629 billion mega cap, as the ETF’s largest holding. Biotech CRISPR Therapeutics AG and genetic diagnostics firm Invitae Corp. — both with market caps just under $10 billion — are among the fund’s top 10 holdings.
This active approach allows Wood to span industry classifications and market sizes. According to Morningstar, over the five years through July 2020, the average market cap of companies within her flagship portfolio never topped $10.5 billion, consistent with her goal of finding under-the-radar companies the market doesn’t fully appreciate. Over the last year, that fund gained over 200%.
The assets under Wood’s management have expanded with her stardom and forced her to deploy the new billions in more established large-cap companies. However, she still tries to stay with smaller names. Close to 30% of Ark Innovation is invested in companies with less than $10 billion market cap, data compiled by Bloomberg Opinion shows.
This active and adaptable approach is music to the ears of young retail investors bored by the old blue-chip growth stock pitch. Thematic ETFs like Wood’s — which invest in categories such as innovation, tech, health care, clean energy, or even cannabis — saw rapid growth over the last year, with assets under management now at $156 billion, versus $56 billion as of 2019, according to Goldman Sachs Group.
These ETFs have proven staying power and are no longer the gimmicks decried by some analysts. According to Bloomberg Intelligence analyst Eric Balchunas, thematic ETFs have gained 63% over the last year. During the recent Nasdaq selloff, investors pulled only $700 million from them — not even 1% of total assets under management — for the two weeks ending March 5.
Even within the thematic ETF category, investors seem to prefer the most nimble ones. About 85% of the funds, such as the $10.4 billion First Trust Dow Jones Internet ETF, are still passively managed. But active funds, such as ARK’s family of ETFs, manage 32% of the total assets in the category. Investors don’t seem to mind that ARK’s flagship fund charges 0.75% management fee, quite a bit higher than the 0.2% expense ratio of the $154 billion Invesco QQQ Trust ETF, an index fund that tracks the Nasdaq 100. After all, she has delivered.
There’s been some recent skepticism about ARK’s concentration risk. Wood is getting too big for the small-cap space she’s hunting in, critics say. As billions pour in, her management firm now has at least a 10% stake in more than two dozen companies. An exodus from her funds, they say, could spur a wider market selloff and vice versa.
That concern is overblown. Index funds have exactly the same problem. For instance, in terms of daily trading turnover, the iShares Russell 2000 ETF, a $72 billion whale, is a big market mover in a range of small-cap banks such as Tompkins Financial Corp. The ARK family is only really influential with a handful of small health care stocks, such as Iovance Biotherapeutics Inc. and Veracyte Inc., data provided by Goldman show. With Wood getting so much retail investor love, it’s no surprise she attracts jealousy and naysayers.
The rise of Cathie Wood is great news for retail investors. She is engaging. We can browse through her research, listen in on her monthly briefings, and even track her portfolio moves, which she discloses daily.
After all, why should we be passive, dumb money pipelines, willingly handing billions to a bunch of professionals who just hang around the FAANG stocks? An equity investor with some financial literacy can pursue a so-called barbell strategy, putting a large chunk of her money in a few inexpensive index funds, while picking out a couple of unique, thematic funds that could offer big upsides. If this trend continues, small-caps will soon beat the big Nasdaq whales.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
To contact the editor responsible for this story:
Howard Chua-Eoan at [email protected]