Young tech investors today don’t seem to care much about risk. If they did, they would first have to define the risk. For a given equity portfolio, a common risk is that of correlated returns (when the actions move together in the same direction). This is why diversification is such an important concept.
If you invest in a stock, you are overdosing on the specific risk of the company. If you only invest in small caps, it is a big bet that increases the risk. If you only buy US stocks, you are exposed to single country and currency risk. If you only buy health care stocks, it is a risk of exposure to the industry. And if your stocks evolve together as a group even though they are not part of the same industry – gene editing stocks and 3D printing stocks are two good examples – then that’s a risk that doesn’t. is not so obvious.
Risk can also be defined as “the volatility of returns”. When external factors increase volatility, we need to assess them. A risk factor that increases the volatility of our portfolio is the “ARK effect”.
What is the ARK effect?
The “ARK effect” is simply the extent to which ARK Invest – the main manager of thematic funds – influences the price of certain disruptive technology stocks. Their success story has become a double-edged sword. Like ARK asets under mmanagement (AT M) have taken off, they have been forced to acquire more and more shares of the companies they own in a very short period of time.
As a result, they own an unusually high percentage of certain companies. This poses a problem if they are to sell their stocks quickly on the basis of the principles of supply and demand. Just look at this amazingly thoughtful table CNBC set up yesterday to demonstrate the ARK concentration problem:
If you own Statasys shares (SSYS) or Photo labs (PRLB), you should be worried. Why? Because when ARK suddenly needs to sell shares of these companies, they will drive the price up by the floor. When they need to buy more shares, they’ll send the price through the roof. In other words, the ARK effect is what happens when a large, successful fund manager is limited to a small universe of stocks. The result is increased volatility for many of their larger holdings which are more correlated than not. Complicating matters even more is the way ARK ETFs overlap, which we discussed in our recent ARK Space ETF article. For example, three of their top five actively managed ETFs own 10% or more of Tesla.
In the table below we have taken the five largest actively managed ETFs of ARK Invest (representing nearly $ 40 billion in assets under management) and listed the top 15 titles according to ETFdb.com. We then marked all duplicate stocks – stocks that exist in two ETFs are yellow, while pink denotes stocks held in three or more ETFs:
Tesla likely has the cash to back ARK by suddenly selling a shipment of stocks, but other companies can’t. Selfishly, we’re just concerned about how much exposure our portfolio of disruptive tech stocks is to the “ARK effect”. We will keep it simple. What is the total weight in our own portfolio of all the stocks listed in the table above? It turns out that we have seven for a combined weighting of 10.7%. (Nanalyze Premium annual subscribers will know which ones.) So what type of risk does this exposure represent? The answer might surprise you.
The ARK effect goes both ways
As ARK quickly moved to accumulate this concentrated list of stocks, it would have pushed prices up – (demand exceeds supply). As a result, some investors may have overpaid for their shares. When investors exit ARK funds and have to sell stocks, prices could drop – (supply exceeds demand). Since this gives us the ability to buy assets at a cheaper price, it means we really want to own quality companies that may be impacted by the ARK effect. In both scenarios, volatility increases with risk. Since ARK mainly operates actively managed funds (they do not follow the benchmarks), things can get complicated very quickly. This is just one of the many criticisms voiced by financial experts.
Take out the reviews
When you are successful, you are bound to have criticism. As ARK Invest ETF returns slowly recover on earth, many people are there to point out their shortcomings. One such reviewer is a Morningstar strategist who published an article a few months ago he gave ARK a good disguise.
You can tell this gentleman is an ambitious go-getter because he
wasted invested 3 years of his life studying after work to reach the VSharassed Financial Aanalyst (CFA) designation. He also has an MBA, but luckily did not include these letters. (People who put “MBA” after their name are of the same ilk as those with a doctorate in gender studies and refer to themselves as “Dr”.) And we only pity him because he criticized ARK analysts saying, “hardly any of the ARK analysts have progressed beyond obtaining a bachelor’s degree.” To be fair, he might be onto something. Exhibit A:
When an ARK analyst asked on Twitter to speak to the CEO of Bionano Genomics, shares exploded days later. Coincidence? Maybe, but if this boy thinks talking to a corporate CEO is a viable way to assess the merits of a stock, he’s going to be in for a big surprise. Maybe that’s why ARK has invested in names like Organovo and Nano Dimension, two companies that are more lost than a deaf guy playing bingo. ARK Invest said yesterday:
Yes, we would all like to know more about Organovo’s plans given that they have done everything since we started to ask ourselves “where is the income?” ” six years ago. At least they’re not as bad as Nano Dimension, a $ 1.82 billion company with revenue of $ 811,000 in the first quarter of 2021. Using our simple valuation ratio – market cap / annualized earnings – we have the highest valuation ratio we’ve ever seen for a disruptive tech stock – 561.
The Morningstar article talks a lot about ARK’s appetite for risk and – at least according to the author – a reluctance to manage it by employing risk management professionals to test certain scenarios. (Given ARK Invest’s relationship with MSCI, it is hard to believe that they have not yet been sold a risk management solution.) The Morningstar article says:
The portfolio of its flagship strategy, ARK Innovation, is very heavy, makes huge bets in the industry, and has historically invested in publicly traded companies of virtually all sizes. It encompasses companies that lose money so long as they invest aggressively to exceed their already high growth expectations.
ARK does not have a market cap threshold, so they will invest in small companies and treat them with the same care as large ones (Organovo has a market cap of $ 67 million). They also invest in pre-income companies, which we strongly advise against. When it comes to geographic location, ARK explicitly states its domestic bias, opting for stocks primarily traded in the US in its portfolios. So far, their strategy has worked pretty well, but the volatility is going both ways.
When tech investors stop caring about risk, bubbles appear. ARK maintains that they are invested in “high value” stocks that have been overlooked and undervalued. Their bullish stance on bitcoin embodies their desire to invest in what might happen tomorrow versus what happens today. ARK’s Midas touch means that any stocks they invest in become self-fulfilling prophecies as traders move quickly to trade these signals. But the hype and tons of capital will only get a business this far, unless it can produce an economically viable product or service that generates significant revenue growth.
The solution for disruptive tech investors is simple. If you are investing in a stock in which ARK has a large position, you better be comfortable buying at a much cheaper price.
ARK Invest increases the volatility of the stocks they buy and sell – the ARK effect. To offset the risk of the ARK effect, we sold their flagship ETF and used that money to buy other assets that are not owned by ARK and likely never will (a cybersecurity ETF and a stock of batteries). If you’re an investor in disruptive tech stocks, now is the time to assess your exposure to major ARK stocks, which isn’t necessarily a bad thing if they are quality companies.
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