ARK Invest has repeatedly made headlines over the past year as the firm rocketed from $3 billion in assets at the beginning of the year to $35 billion by the end of 2020 on the back of astonishing one-year performance of 152% in its flagship product, ARKK. Such rapid growth in a strategy known for investing around the world and up and down the cap spectrum has caused some observers to question how the approach can handle large inflows (or potential outflows) when it owns such large percentages of some small companies’ available shares.
I sat down with ARK Chief Operating Officer Tom Staudt to explore some of these tougher questions.
Dave Nadig: Tom, let’s just start at the beginning. I think the core investment thesis of ARKK – a concentrated portfolio of companies with exponential growth potential over a five-year horizon – is well understood. But how do you mesh that long-term strategy with the short-term volatility in your own flows and portfolio companies? People bring up examples of old mutual funds that have had to close and so on. How do you respond?
Tom Staudt: First and foremost, this is a process, and one where we certainly think about liquidity and capacity. You have to. We monitor risk metrics for every position, and we take the liquidity in those positions seriously. That said, I think that there are key differences between the ETF structure and some negative historical examples, especially when compared to mutual funds, both because of the vehicle difference and because of the strategy difference.
One difference is that some mutual funds have had very illiquid – even non-traded — investments. ARKK is still a highly liquid portfolio of traded public equities based on SEC guidelines and financial accounting standards. We believe there is a market every day for every security that ARKK owns.
Dave: Can you explain what would happen in the portfolio should you see a large rush of redemptions? Are there any considerations of ‘what to get rid of’ in that environment? And even before that – how often are you rotating names? That’s not always easy to suss out of a data report.
Tom: It depends a little bit on which fund you’re talking about. On average, we turn over about 15% of the names in our portfolios each year. You certainly see more name turnover during down markets than you do during up markets, which probably is not a surprising statement. But generally, the reason you see that is that the portfolio team will concentrate more … they’ll buy the dips in their highest conviction names. During corrections, we concentrate our portfolios toward stocks that we believe are most misunderstood. When you balance these things out, while name turnover typically is roughly 15% per year, total turnover – which includes trading around the volatility in the stocks in our portfolios – can be 75% per year.
Dave: OK, so let’s imagine that a large sustained period of redemptions hits ARKK, or even the whole complex. How would that actually play out? Let’s think of it in the flows space.
Tom: Well, hypothetically, if you have a big redemption in the ETF structure, market makers can do that unwind in a pro-rata manner, which is just using the typical basket approach for an ETF. In contrast, some mutual funds have had very illiquid instruments historically – extremely illiquid junk bonds and non-traded equities – and they weren’t able to sell down the portfolio to meet redemptions in a pro-rata manner. They had to sell their most liquid names, not the most illiquid names. And so what happened is the portfolio actually got more and more illiquid as it got smaller. We don’t believe that is likely to happen to ARKK.
Dave: Just because it’s an ETF? ARK, across the firm, can have upwards of 15% ownership in some of the smaller names. So it seems reasonable to ask how you manage a position that concentrated.
Tom: Generally, we seek to keep our names under certain ownership percentages. However, a holding might appreciate beyond such so it’s not a mechanical limit but triggers additional monitoring.
Dave: Let me push back there for a second. You run a variety of ETFs and mutual funds and SMAs – many billions of dollars. I assume if you want out of a particular name for some reason, you’d be exiting the position across the firm, which means the total amount you own could be quite large, and thus tricky to unwind, no?
Tom: Generally, I think that’s a reasonable thing to discuss, but let’s think it through. First, if we’re just getting redemptions, the redemption process just transmits that selling pressure directly into authorized participants’ baskets, as you’d expect.
Dave: What about if you want out of one of these single names?
Tom: Our portfolio management and research are based on five-year time horizons. Short-term changes in the market typically don’t impact our long-term theses. Now that’s not to say it’s impossible we enter or exit a position quickly, but let’s talk about exiting.
Scenario One: the market has really gotten excited about a name, and we think it’s overpriced relative to our expectations over a five-year time horizon. In that case, we’re clearly a liquidity provider, right? The market wants into the name. We’re exiting the name. You’d expect significant liquidity well above a normal average daily volume. And we’re providing liquidity to the market, not taking liquidity.
Dave: Right, because in that case, you’re selling into a hype.
Tom: We’re selling into the momentum. So that’s scenario one. That has happened. That has happened in a couple of cases, historically for us where we were right about a company, and we thought the market just got way ahead of it.
So Scenario 2: flat markets, normal liquidity. In that case we can expect the normal creation/redemption process to work. It’s no big deal because as we just said, we’re in flat normal markets.
But Scenario 3 is what you’re talking about: what happens if we’re selling into an event, some kind of external desire to get out of a name? There, being an ETF really helps us. In an extreme case, we can do this with a custom basket, and that’s probably the part that never gets talked about. If you really get into a situation where you want out of a name, we can work with authorized participants to in-kind out of the name we’re exiting through custom baskets. People talk about the short interest in some of these names. Sometimes those are the names that market-makers want to do a custom basket on because they can close a bunch of positions all at once without going into the market and driving the price up by covering their shorts.
Dave: Have you done that historically?
Tom: Very rarely. There hasn’t been a ton of reason for us to do it based on how and what we’re trading. Our position management is usually very much around the edges and that doesn’t lend itself to custom baskets. We only gained the ability to orchestrate custom baskets with the passage of the ETF Rule [6C11] last year. But now we can do this when we need to, as long as it’s in the best interests of our clients and based on our compliance policies and procedures.
But let’s just ‘what-if’ the extremes. If we wanted to completely get out of a stock suddenly, we have 21 Authorized Participants. We can simply say ‘we’re exiting this’ and there’s a high likelihood a few of them are going to want to take it, whether to balance their own order imbalances or just cover short positions on their books.
And if we imagine some sort of truly newsworthy event, then generally there’s tons of liquidity. You might not like the price, but big negatives tend to bring big liquidity. That’s the market, right? For example: we’ve never shied away from the fact that we owned some, not a ton, but some Wirecard [Editor’s Note: German payment processor Wirecard was implicated in a high-profile accounting scandal in 2020 involving several members of senior management, and eventually became insolvent]. Wirecard went through alleged fraud. There was no nuance there for us. We saw potential fraud. We got out the same day.
Dave: You were willing to take the pain to just get the heck out?
Tom: Let’s be honest, that was a very, very, very liquid day, right? I mean, we’re definitely talking standard deviation. And, as compared to some managers who either couldn’t act or didn’t act, it ended up being a very good trade for us that we got out on that very day. Did we lose money on the position? Yes, we did. We read the auditor’s reports and thought that the company was really being audited, but hey, you know what? We were wrong. It was deemed criminal fraud. The thesis was there, but we didn’t think they were stealing and lying to the auditors, but apparently they were.
So we did not sit around and say, “Well, hey, maybe we’ll custom basket,” or “Hey, maybe it’ll bounce.” There was no reason to hold it. We got out. And it turns out it really did go to zero. But we got out.
It’s the market. That can happen. You hate when that happens. You don’t plan on that happening. You try your best to prevent it. That was a case of just pure fraud apparently. I’m not saying that’s a great moment for us, but it does demonstrate that in a true crisis, average daily volume statistics don’t mean very much.
Dave: Definitely an outlier event.
Tom: Compare that to a situation where there was no event. Company’s still trading. It’s all fine, right? We could have been done a custom basket and say: we would like to get out of this position. We know we’re exiting wholly. We can run this through a custom basket because we’re going to sell the whole position. The market’s not going to really know until we’ve published the next basket, when they see the name has disappeared.
Concentration & Price Discovery
Dave One of the criticisms folks have had about ARK’s concentration is that effectively, trading in one of these funds becomes the price discovery for the underlying, because the flows in and out of something like an ARKK, ARKF, or ARKG, on any given day could represent a significant portion of the implied trading in the underlying, which means that the flows themselves become the price setters for the holdings.
Now, obviously, there’s nothing passive about any of this, but this idea of trading whole portfolios without regard to individual price dynamics and how flows can impact those prices seems like a reasonable avenue to discuss.
Tom: I think it’s a fair question. I would argue, though, that the concentrated portfolio should be, theoretically, more closely linked to true price discovery than broad-based index funds, because, to the earlier part of this conversation, we are concentrated. There are only so many names. And we’re transparent.
If you’re buying a fund, it’s just a basket of these names. You could buy the stocks. You could buy calls and puts. You could buy options. Or you can buy this ETF. We’re just another demand vector for the stocks. You can’t divorce ARKK from its underlying holdings, because that is what the ETF is. Obviously, we’re disclosing the holdings, but we’re disclosing all of our research as well. And I think that the demand and thus the price discovery should be linked to the ideas.
Dave: Let me push back on that a little bit. There is no fund out there in the world that is going to absorb all the S&P 500 flow for the day in one vehicle. Even SPY doesn’t do that.
Tom: I think that our ETFs are an important signal of demand for these spaces. And I think investors have the right to a tool accessing these themes and industries, and I don’t think it’s just limited to us. I think you could argue that it’s true for any thematic. I would say the solar ETFs, regardless of their size, have a dramatic impact on solar companies, because there’s only so many of them, and when the solar funds are buying them, they’re moving the space. Same for frankly any of the concentrated theme funds we’ve seen launch. But they’re going up or down because the price discovery is reflecting the demand or lack of demand, effectively, for all of them. And I don’t think what we’re doing is radically different. If people are investing in our funds, or the underlying stocks, the demand for this theme of innovation, or of genomics, or of robotics, is going up. Price discovery should follow. It should go up, or in reverse, it should go down. Price should follow changes in demand up and down. To me, that’s the sign of a really healthy market structure.
And, yes. Prices could go down if investors are suddenly expressing lower demand for genomics or some other theme tomorrow than they are today: that’s fair market discovery.
How can a market accurately reflect something that they don’t know? That’s why we’re so committed to transparency. I’m not talking about the mechanics on the backside. I’m talking about the end investor. At least with ARK’s approach, you know which companies make up our genomics strategy. If you don’t think these are good names anymore…
Dave: …then don’t buy it.
Trading Around the Margins
Dave: One of the unique things about ARK is that you publish a trade blotter every day. I think I may have been on the desk of the last fund to do this [OpenFund, closed 2001]. My sense from reading it is that you’re actually doing pretty classic position management – 30-40 bps readjustments based on market conditions. How does that gel with the five-year time horizon?
Tom: You’re absolutely right, our average trade is really around the margins daily. And the reason for that is actually because valuation is very important to us. And so when you have a long-term time horizon, we have a scoring metric. We’re evaluating these companies. We have bottom-up models that are informed by our top-down thematic research. But at the end of the day, you have a five-year price target. It’s simply the average projected five-year annual rate of return. So that constantly changes based on price and in relation to the rest of the portfolio.
If the name is up quickly, you can pull back, take some profits. If a name is hit for reasons that don’t impact your five-year outlook for any short-term reason, we’ll leg in. A lot of times — probably the most common case — is when a company announces earnings, misses by a couple of pennies, but beats on revenue. Often it’s because they invested aggressively … so our five-year outlook may actually increase, but the stock gets hit. We generally are unconcerned in these scenarios due to our focus on certain metrics that others may not give as much weight to, or miss out on entirely.
Dave: You’d rather have them do that than get timid because they’re trying to hit their quarterlies.
Tom: That’s exactly right. We’d always, always, always want that because we’re talking about innovation. There are huge first mover advantages. These are often winner-takes-most markets. And so, we’ll happily average down and we’re going to sell a stock that has a relatively lower average rate of return because of its strong performance. So we’re trading on the margins. It doesn’t mean we’re legging in or legging out of positions. It means we have reacted to the market opportunistically. There’s more volatility in the innovation space than in the broader market. I don’t think that’s a very controversial or enlightened statement.
Beyond the Mechanics
Dave: Tom, thanks for the time. We could have hit another dozen topics and maybe we’ll run it back. But any closing thoughts before we sign off?
Tom: Honestly, on all of this, here’s the bottom line: markets are complicated. Markets don’t lend themselves well to a one sentence soundbite from a non-market structure expert. I mean, to your point, the two of us could dig in, we could do another hour and a half just on any one part of this conversation. And it would be fascinating to a very small group. That complexity also makes for opportunities if you’re willing to do the work.
Part of our mission is to educate about all of this complexity. That’s why the research has always been free. We’ve never charged for research. It’s not behind a pay wall. Anybody can sign up. Our competitors can sign up. Our friends can sign up. People who never invest a dime with us can sign up. That’s okay. We’re held accountable that way, and accountability is completely fair and transparent. Part of that, though, is to say, “This is what we think the world is going to do. This is going to have an impact not just on your lives, not just on our lives, but on everybody’s life.”