Potential Liquidity Issues at ARK Invest

Bad Performance Might Expose a Liquidity Problem

On February 16, The Bear Cave highlighted potential liquidity issues at ARK Invest, the hot active ETF firm founded by Cathie Wood that has seen assets grow from around $10 billion to $60 billion over the last 12 months. On February 23, The Bear Cave reiterated liquidity concerns about ARK Invest. Later that day, Cathie Wood said,

“We love a wall of worry. We saw it on social media, lot of chatter, some of it just waiting for our fund in particular to take a tumble, maybe to buy and some happy to sell and short and all that.”

ARK’s flagship Innovation ETF is now down 20% from its highs and is beginning to face outflows. The illiquidity risks are serious and worsening.

ARK’s illiquid holdings are problematic because as ARK faces redemptions, hedge funds could take predatory short positions in ARK’s illiquid holdings and create a performance death spiral. A review of ARK’s illiquid holdings shows that could be happening:

How bad can it get?

Copper River Capital provides an example of what large forced transactions can do to markets. In September 2008 the short-focused fund faced margin calls after Goldman deemed its cash held at Lehman Brothers invalid. The firm was forced to cover large short positions quickly and drove positions upwards of 40% against themselves within days. Part of the short-term upwards jerk was hedge funds front-running with their buying.

Replace margin calls with forced selling, and you could have the same thing happen in reverse with ARK. What makes ARK’s situation potentially worse is the heavy retail participation in many of its names. Retail investors may be fickler and have price drive sentiment. As a result, any declines in ARK’s illiquid names may drive copycat selling by retail traders playing with momentum.

In addition, Bloomberg recently reported that Nikko Asset Management, a Japanese firm, copies many of ARKs strategies for Japanese investors. This makes ARK’s illiquidity even bigger than it seems. For example, when accounting for the shares owned by Nikko, ARK + Nikko own “at least 25% of three firms” according to Bloomberg.

In a YouTube video last Friday (February 26) Cathie Wood addressed some of the illiquidity concerns and said:

“There is a misunderstanding of illiquidity when it comes to ETFs…” (33:38)

“As a portfolio manager, I know the difference between an ETF wrapper and a mutual fund wrapper. A portfolio manager in the ETF does not need to worry about flows…” (36:23)

“I have been surprised by some of the ETF commentators. They should know better, but they haven’t managed money…” (37:31)

Ms. Wood highlighted that ETFs have different inflow and outflow structures than mutual funds. ETFs grow and shrink as authorized participants create or redeem shares of the ETF. If an ETF trades below NAV, an authorized participant can buy the ETF, generally convert the ETF into the underlying holdings, and then sell the holdings. This helps the ETF trade up to NAV, but it does not change the selling pressure in illiquid names. Read more on the ETF creation/redemption process here and here.

ARK Invest sends daily emails to investors with its ETF trading activity. On Friday, February 26, ARK Invest expanded its disclaimer to 718 words compared to 163 words on Thursday, February 25. Below are two new additions:

“Additional risks of investing in ARK ETFs include market, management, concentration and non-diversification risks.”

“There can be no guarantee that an active trading market for ETF shares will develop or be maintained, or that their listing will continue or remain unchanged.”

In Friday’s daily trade email ARK also disclosed increasing its stakes in Repare Therapeutics (NASDAQ: RPTX), a $1.2 billion drug company, Vuzix (NASDAQ: VUZI), a $1 billion tech company, and Atlas Crest Investment (NYSE: ACIC), a $600 million SPAC.

Short-sellers appear to smell trouble brewing. According to one trader, the borrow rate on ARK’s Innovation ETF (ARKK) reached 19% yesterday.

Reddit traders are raising alarms too. One post titled, “Investors beware: $ARKK is a liquidity disaster waiting to happen” was upvoted over three thousand times. It read:

“I ran an analysis on the weekly net flows into ARKK over the last 60 weeks, and found that portfolio performance of the ETF was highly correlated with ETF inflows… lack of liquidity becomes a much bigger problem when investors are selling and when the broad equity/tech markets have a correction… I am concerned that many people may not be aware of these risks, and unfortunately the small investors in Cathie's funds will be the ones who bear the brunt of any crisis.”

A separate post in the WallStreetBets subreddit titled, “The Real Big Short: Passive Investing, Positive Feedback Loops, and The Massive Ark Bubble” recommended buying ARKK puts.

ARK Invest derives its name from the Ark of the Covenant, a gold chest that contained the Ten Commandments, according to an interview Ms. Wood did with the Christian website Jesus Calling. In that interview, Ms. Wood reflected on her prayers during the tough early days of ARK and said,

“And I would kneel down and say, ‘Okay, God, You’re in control. Even if this company fails, I know I’ve done the right thing. This is a walk of faith for me. Your will be done.’”

Disclaimer: Hi there, Edwin here. I’m a 22-year-old passionate about the public markets and the sole author of The Bear Cave. I have no position against ARK or its portfolio companies and this is not investment advice. This article expresses my opinions and I hold no licenses. Always do you own research before making investment decisions.

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