Thematic-investing specialist ARK Investment Management has been in tune with the market’s unfolding narrative in recent years, but its lone portfolio manager, inexperienced team, and lax risk controls make it ill-prepared to grapple with a major plot twist. Its flagship strategy, ARK Innovation ARKK, earns a Morningstar Analyst Rating of Neutral.
The Pitch and the Niche
ARK believes that equity indexes are full of value traps in danger of technological obsolescence and that traditional asset managers hew too closely to their benchmarks, thereby loading themselves up with stocks in doomed industries. Its solution is to invest across five technology platforms--artificial intelligence, blockchain, DNA sequencing, energy storage, and robotics--that it thinks will revolutionize how economic sectors across the globe operate.
True to form, the firm’s products look unlike any index. The portfolio of its flagship strategy, ARK Innovation, is top-heavy, makes huge industry bets, and has historically invested in publicly traded companies of virtually every size. It embraces money-losing companies so long as they’re aggressively investing to exceed their already high growth expectations.
The firm defines success differently from most long-only funds. Rather than aim to outperform an index, the firm cares most about achieving high returns and invests only in companies it thinks will gain 15% or more annualized over the next five years. That hurdle is roughly double the annualized return of the Russell Mid Cap Growth Index (the fund’s category benchmark) since 2000.
The firm’s exchange-traded fund lineup has done far better than that. Its flagship strategy, which combines ideas expressed in its six other actively managed ETFs, gained 150% in 2020. A flood of inflows followed. Over the 12 months through February 2021, the firm’s total assets under management leapt to roughly $80 billion from less than $12 billion.
The firm is shareholder-friendly in some ways. It has developed its product lineup thoughtfully by maintaining its focus on the handful of innovation platforms and underlying technologies it thinks have longevity. Its ETFs are cost-competitive relative to actively managed rivals.
But few features of its research team or process suggest ARK Innovation will continue to beat the Russell Mid Cap Growth Index on a risk-adjusted basis.
The Key Person
ARK’s main draw is its founder, chief executive officer, and portfolio manager Cathie Wood, who, after more than three decades in the industry, launched the firm in 2014.
She honed her thematic-oriented process at AllianceBernstein from 2001 to 2013, where she ran several strategies similar to this one that had high volatility, poor downside performance, and underwhelming long-term results during her tenure. During her 12 years at the helm of large-growth separate account AB MA Strategic Research, its before-fee total returns comfortably outpaced the Russell 1000 Growth Index but lagged on a risk-adjusted basis. She also managed two growth-oriented mutual funds--one focused on domestic mid-caps, the other on global stocks--whose net-of-fee results underperformed their bogies on her watch, risk-adjusted or otherwise.
And yet, as ARK’s primary investment decision-maker who has established a ubiquitous media presence and enthusiastic following, Wood is essential to the firm’s continued success. Director of research Brett Winton would likely succeed her if needed, but his nearly 15 years of industry experience include none as a portfolio manager. Exacerbating that key-person risk is the firm’s inability to develop and retain talent: Many of the analysts supporting the funds’ research have come and gone, and most of the remaining nine lack deep industry experience.
Not Your Typical Analyst Team
The firm's analyst bench is distinct from traditional asset managers, but not in a good way. The typical equity research analyst in the asset management industry has a predictable set of credentials: an undergraduate degree from a name-brand institution, some entry-level work experience, an MBA, an analytical internship, and at least some progress toward investment-related credentials, such as becoming a CFA charterholder. Almost none of ARK's analysts have progress beyond earning bachelor's degrees.
Indeed, ARK's research-related job postings tend not to demand credentials of any kind. That sort of openness expands the applicant pool and invites individuals of various backgrounds and experiences to submit their resumes. The firm may be on to something there. Cognitively diverse teams can be more creative or innovative than those without a variety of perspectives. (1)
But this team’s collective experience seems significantly more limited than that of other firms. Only about half the current team came to ARK with a history of full-time work.
ARK outsources much of the technical expertise to "theme developers"--some of whom the firm says are academics, entrepreneurs, and former ARK analysts--who donate their time. It also invites feedback on its research and new investment ideas from individuals following the firm through social media. These features make the firm's process of gathering and digesting information unique, but its analytical edge remains unclear in an industry that provides (for a fee) subject-matter experts to advise shops that lack requisite technical know-how.
A Peculiar Analyst Coverage Model
Wood thinks other asset managers set up their analyst teams poorly to comprehend the potential impact of these technologies on the economy. Rather than assigning analysts coverage of economic sectors--a common industry practice that Wood thinks creates information silos--ARK assigns them one or more technological specialties. For example, one analyst covers energy storage, robotics, and reusable rockets; another covers automation, robotics, energy storage, alternate energy, and space exploration.
Wood has a point. Technology is crucial to both its purveyors and consumers and influences the sales and expenses of companies across all industries. It follows that analysts who can accurately forecast the accessibility, cost declines, and adoption rates of the most promising innovations could have a stock-picking advantage. But her views on this don’t radically diverge from her competitors. Many recognize the downsides of industry specialization and try to mitigate them by fostering collaboration across sectors or implementing a generalist approach.
In some ways, ARK’s setup could lead to ultra-specialization and potential blind spots that better resourced firms wouldn’t miss. For example, it assigns DNA sequencing, genome editing, and immunotherapy to two analysts who are early in their careers and at a disadvantage to their healthcare-focused rivals. The teams of other shops collaborate to cover biotech, pharma, and life-sciences firms in breadth and depth and staff their teams with seasoned analysts holding doctorates or other advanced degrees in medicine, biology, or neuroscience.
Unrestrained, Unaware, and Unconcerned
ARK Innovation’s benchmark agnosticism and high return targets saddle the portfolio with risks that Wood manages mainly with instinct rather than data or rules. The firm, which has no risk management personnel, views the subject almost exclusively through the lens of its scoring system that monitors six inputs to a stock’s investment thesis. They are:
1) Company, People, and Culture 2) Execution 3) Moats: Barriers to Entry 4) Product Leadership 5) Valuation 6) Thesis Risk
These form the basis of levelheaded bottom-up research--most investment teams use some variation of them--but they provide little visibility into the portfolio’s aggregate risk exposures.
Wood assembles the portfolio one stock at a time, using each stock's cumulative scores as a guide to position sizing. But these scores say nothing of each stock's sources of risk and return, which may be highly and undesirably correlated to one another. There is potential for diversification across innovation platforms--but the firm's self-categorization of its investable universe does not by itself imply a rigorous understanding of which stocks are likely to rise, fall, succeed, and fail together. Forward-looking estimates of the holdings' correlations and variances or other input from a separate risk-management team, on the other hand, would do more. (2)
Such analysis is complex and nonessential for most of this strategy’s rivals. That’s because the typical long-only equity strategy defines its risk limit and stays within it, for example, by anchoring its sector weights to prevent extreme sector concentration. ARK has few portfolio construction parameters. It has said it will generally invest no more than around 10% of ARK Innovation’s assets in a single company (it has adhered to this guidance) and no more than half of ARK Innovation’s assets in a single technology.
To be sure, ARK makes no promise to diversify its portfolios, and it tells investors to expect volatility. But even a high-octane strategy like this one should be cognizant of the risks embedded in its portfolio and manage to a definable risk tolerance. It seems not to. Indeed, on March 29, 2021, the fund removed prospectus language limiting the size of its top positions and its ownership percentage of individual companies' shares outstanding.
Blind to the Future
The portfolio has become less liquid and more vulnerable to severe losses as its size has swelled. In the 12 months ended February 2021, the ETF’s assets under management grew more than tenfold to over $23 billion. It has retained and grown its stakes in small companies that are now much more difficult to sell without materially impacting their stock prices. Across all U.S.-domiciled funds, the ETF stood out in February for having the most concentration in companies in which it owned 10% or more of floating shares--that doesn’t even include additional vehicles tied to the strategy, which combined amount to another $15 billion.
The firm has minimized the notion that the ETF's downside has become steeper, mostly by relying on the past as a guide to the future. But its heft is new, and future market crises will be different from previous ones. Without risk-management professionals to stress-test the portfolio's risk exposures, estimate its potential losses during historical or hypothetical market environments, and gauge worst-case scenarios, the team is poorly positioned to prepare and react.
But even with such a team, there’s no sign that Wood would heed its advice. A central tenet of her process is to amplify exposure to the fund’s riskiest holdings when market uncertainty is highest. In a market crisis, her game plan is to sell first the fund’s “cashlike” stocks--those that possess the most diversified sources of revenue, are typically large cap, and are the most liquid--to favor as few as 32 “pure plays” that are often unprofitable small caps that are less liquid and extremely volatile.
She followed a much milder version of this playbook at AllianceBernstein’s Strategic Research strategy during the market’s 2008 implosion. There, she consolidated the portfolio to 47 or so stocks and kept it focused on liquid large caps. It did not have anywhere near the level of ownership in individual companies as ARK Innovation has today. In 2008, that large-growth-oriented separate account lost 45% before fees--substantially worse than the Russell 1000 Growth Index’s 38% decline.
Other potential consequences of the strategy's size are less dire but hinder its ability to exploit good ideas and oust bad ones. Nimble execution is now tougher than before. To mitigate market-impact costs, ARK must build new positions more slowly and exit gradually. But its bullish or bearish signals are available for all to see--as an ETF, the strategy must disclose its portfolios to the market each day--and traders can respond either by buying up a stock’s known supply (putting upward pressure on its price) or selling it (downward pressure) before ARK has offloaded its own position. (2)
ARK’s pursuit of disruptive innovators has merit, and its quest for big rewards may appeal to aggressive investors who can stomach the risk of potentially heavy losses. But ARK’s team of inexperienced analysts, go-with-your-gut risk management approach, and bloated asset base raise doubts about whether this fund’s outstanding historical results can continue.
1. Woolley, A.W., Aggarwal, I.; & Malone, T.W. 2015. "Collective Intelligence and Group Performance." Current Directions in Psychological Science, Vol. 24, No. 6, P. 420. DOI: 10.1177/0963721415599543.
2. Lussier, J., & Reinganum, M. 2018. Active Equity Investing: Portfolio Construction. CFA Institute.