Cathie Wood.

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. 

Think Small

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. 

Rise of the Rebels

Source link