Introduction: ARKK, the ARK innovation ETF had fallen 58 percent from its all-time high by late January 2022. The fund is experiencing massive outflows.
What could Cathie Woods have done differently?
Is there a way to create a fund that targets the most innovative companies but takes on less risk and does not experience this type of massive decline in value when things turn south?
Analysis: Two Problems with the ARKK Investment Approach:
There are two problems with the ARKK investment model that led to this debacle.
The first problem involves an incorrect perception of the extent of diversification of the ARKK fund.
The ARKK fund, despite having 153 holdings, is not highly diversified. The ARKK holdings have similar characteristics. The firms are young, innovative, and risky.
When risk appetites fall, as they are currently these firms fall in tandem.
A portfolio manager could have a reasonably diversified portfolio based on either 153 randomly selected firms or 153 firms selected from different sectors of the economy. Much less diversification is obtained from a 153 similarly situated firms.
(It is sort of analogous to a person applying to all IVY league schools thinking one acceptance is in the bag because of the law of large numbers. The number of applications is not determinative when all institutions have similar decision rules.)
The tech fund could increase diversification of its holdings by holding 20 percent to 40 percent of its assets in a market portfolio perhaps through a Vanguard S&P 500 fund like VOO. Alternatively, the tech fund could consider putting 20 percent to 40 percent of its assets in more stable value stocks, live VOOV, a fund that is uncorrelated with the startup sector.
A fund investing in high-tech startups needs to hold substantial funds in the general market or better yet invest substantial funds in the market that is not high tech. A fund that invests 50 percent in innovative firms and 50 percent in startups would be able to reallocate assets when tech prices are elevated and make additional purchases during market downturns.
This approach is similar to the approach used by FBALX, a fund that balances stocks and bonds to provide more stable income in one fund. The FBALX fund did well during the 2008 market downturn.
An ETF with both a tech portfolio and a market or value portfolio creates a better risk-return tradeoff than a pure tech startup portfolio. The professional portfolio manager would reallocate assets from the tech component to the value component when tech was high and purchase tech assets when prices crash.
The person managing a combined tech/value ETF would probably be picking tech stocks at bargain prices right now rather than dealing with panic-driven withdrawals.
The second problem Impacting the risk of ARKK involves the existence of some very large positions inside several companies and a general lack of transparency exhibited by most ETFs (not just ARKK) on overall risk.
It is not accidental that Michael Burry, famous for the Big Short, was the first investor to highlight potential problems with ARRK. Michael Burry is famous for looking at the quality of investments inside an ETF.
I quickly looked at some of ARKK holdings. My analysis for this post was limited to 10 holding found on the third tab of a listing by ZACKS. The 10 holdings I looked at were – Fate Theraputics, 10 X Genomics, Docusign, Robinhood, Pacific Bioscience, Pager Duty, Iridium Communications, Tusimple Holdings, Gingko Bioworks, and Twist Bioscience.
My quick analysis found many ARKK ventures were highly speculative and were in the red.
Furthermore, ARKK had extremely large positions in some firms.
- None of the 10 funds had positive earnings; hence, the PE ratio is undefined for all 10 firms.
- The ARK management group was the largest shareholder for 4 of the 10 firms, was the second largest shareholder in one firm, was the third largest shareholder in two firms, was the fifth largest shareholder in one firm and the seventh largest shareholder in another.
ARK is a relatively small fund manager compared to firms like Vanguard, Fidelity, Blackstone, and T Rowe Price. ARKK is a relatively small fund compared to other tach and small-firm growth funds offered by larger firms.
Withdrawals from ARKK leading to the sale of company stock could exacerbate downward pressure on stocks when ARKK had an oversized position.
The recent withdrawals from ARKK and other ARK funds could have and likely did result in additional selling and downward pressure on stocks where ARK had a large position.
In a rational market the fundamentals of the stock prices determine the value of the ETF. My concern is that selling by a risky ETF could spill over and impact the price of certain stocks.
Concluding Remarks: The ARK funds allow investors to get exposure to innovative firms without taking on single-stock risk. However, the amount of diversification offered by ARKK is not as large as some investors believe. The high stakes held by ARK funds likely exacerbated selling and downward price of some tech firms and the innovative company sector.
One additional lesson from this post is that just as one should not judge a book by its cover one should not judge a fund by its profile.