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More space on ARK? (Part 2)

More space on ARK? (Part 2)

Following the first article that revealed the recent success of ARK funds, we consider the question of the fund’s capabilities.

Historical examples suggest that the recent performance of ARK-managed funds may not be sustainable.

After a period of excess performance and inflow of transactions, capacity problems are significant.

Measure and control capabilities

In terms of funds, “ability” is the amount that a policy can receive without compromising its performance.

Each investment policy has a limited capacity, its amount depends on various factors: the breadth and depth of investment opportunities, the underlying liquidity, valuation levels, etc.

An index fund that invests in the US market with positions weighted by market value has a very significant potential. The US stock market is large, deep and generally liquid.

The market value-weighted index is not linked to the valuation of the underlying (the shares of the companies that make it up).

Investors can allocate billions to US equity funds that are weighted at market value without any problems – and they have.

At the other end of the capability continuum is an actively managed portfolio of small stocks.

This narrower segment of the market offers fewer opportunities, less salable stocks and value-sensitive executives. Low value estimates can not raise that much money before they reach a limit.

Too often, asset managers dismiss the problem as less evil.

In fact, receiving more subscriptions from investors has an immediate positive effect on the profitability of their management company.

But failure to manage capacity rationally can be detrimental to investors.

Inflation of assets can lead managers to deviate from their mandate. The new funds they receive from investors can be added to existing positions in their portfolios, which are no longer trading at attractive valuation levels or invested in new positions that are not in line with management’s best ideas.

Too much money to look for too few good ideas leads to increased valuation multiples: it is not a formula for a successful investment.

There are ways for fund managers to prevent or manage capacity problems.

They can focus on larger, deeper and more liquid market segments, such as large US companies.

They can pursue a policy that is indifferent to style (“value” or “growth”).

But the easiest and most effective way to avoid capacity problems is to simply refuse new money.

This can be in the form of closing new investors only (so-called “soft closing”) or both new and existing investors (ie “hard” closing).

This is a fairly common job in small and medium-sized funds that have yielded strong results.

Closing a fund can be a difficult decision for an asset manager.

It goes against their business goals. More property means more income. Taking into account relatively fixed costs within management companies, an increase in outstanding amounts means increased profits and increased profitability.

That said, there are many examples of companies that have long taken a considered approach to capacity management and have regularly closed their funds for the benefit of their investors.

Almost all successful active security selectors have closed funds at one time or another.

Of course, there are also those who could not say no to increased assets and collapsed under their own weight – to the detriment of all concerned.

What about the funds of the management company ARK?

There are growing signs that ARK funds are facing capacity. This is evidenced by the changed outline of its flagship fund’s portfolio and the impact of its trading activities on the market.

ARKK ETF’s portfolio has changed. In the five years from July 2015 to July 2020, the average market value of companies in ARKK’s portfolio never exceeded $ 10.5 billion, in line with the team’s goal of finding companies under the radar that the market does not fully understand.

Since then, the fund’s average market value has skyrocketed to over $ 20 billion in November 2020 and $ 35 billion in January 2021.

A large part of the increase in the market value of ARKK can be attributed to the rapid rise in the prices of many smaller companies in its portfolio.

But as assets have expanded, ARK has also begun to distribute liquidity to established large companies, a change that is changing the composition of the portfolio even further.

From 31 October 2020 to 31 January 2021, the fund opened new positions in 10 companies.

All but three of these companies had over $ 30 billion in market capitalization and three – Novartis, PayPal and Baidu – are mega-caps with a market value of over 100 billion dollars.

It seems that the weight of the fund is partly responsible for this transition to larger equity companies.

As his selection showed strong performance and he added bigger names to the sideline, the presentation of small shares in ARKK’s portfolio collapsed.

At the end of October 2020, 33% of ARKK’s assets consisted of shares with a market capitalization of less than USD 5 billion; At the end of February 2021, these shares were only 14% of the fund. None of these shares rose as a percentage of the fund’s assets during this period.

Even though ARK has moved to a more established, larger company, the company still holds a significant share in many of its smaller holdings.

Looking at the portfolios of five actively managed ETFs, we found that ARK owns over 10% of 26 companies, compared to 24 in October 2020.

This data ignores two of the company’s inactive ETFs, as well as the fund they misrepresent to Japanese asset manager Nikko.

The management company has reduced part of its largest asset and increased others.

The ARK team does not have a formal risk management policy in place with regard to ownership in portfolio companies, but is generally cautious about being considered an issuer’s affiliate by the SEC. , the US stock market police.

According to the SEC definition, an associate is characterized by “the ability, directly or indirectly, to control or influence an individual’s policies and policies, whether through the ownership of voting securities, by contract or otherwise”.

Thus, ARK does not want to put itself in a position where the SEC could question the extent of its participation in the day-to-day trading decisions of any of its holdings.

These important issues raise concerns about capacity and liquidity management.

The more the company owns a significant share in a company, the more difficult it will be to increase or decrease its position without the share price being very different.

For example, ARK owns approximately 25.8 million shares Cerus – a biotech company with a market capitalization of one billion dollars.

Cerus shares are 0.48% of ARKK’s portfolio and 0.44% of Ark Genomic Revolution (ARKG).

In a resolution scenario, assuming the company accounts for less than 25% of last month’s average trading volume, 1.9 million shares per day (an ample amount that assumes near-perfect trading conditions), it would take another 52 trading days to close completely. the situation.

More space on ARK?  (Part 2)

The third part will return to ARK’s management.

© Morningstar, 2021 – The information in this document is for educational purposes only and is provided for informational purposes only. It is not intended and should not be taken as an offer or incentive to buy or sell the securities mentioned. All comments are the opinion of their author and should not be taken as personal recommendations. The information in this document should not be the only source that leads to an investment decision. Be sure to consult a financial advisor or financial expert before making investment decisions.