ARK Invest: Attempting The Improbable

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ARK Invest (ARKK)(ARKW)(ARKG)(ARKF)(ARKX)(PRNT)(IZRL) has faced a wave of criticism in recent months due to the poor performance of their funds. A lot of this criticism is based solely on short-term returns and is unwarranted, as was a lot of the praise they received during the pandemic. ARK’s focus on innovation means that there will naturally be periods of both large gains and losses, dependent on the macro environment and sentiment. Investors would be better served basing their opinions on the quality of ARK’s research and their holdings, which tend to speak for themselves (make of that what you will). Rather than adding to the discussion of ARK’s ability to pick stocks, it is worthwhile looking at the logic of their strategy.

Early-stage technology investments are generally characterized by binary outcomes, with many investments resulting in large losses and a handful resulting in enormous gains. The distribution of expected returns is likely to have a large positive skew, meaning the average return will greatly exceed the median return. This highly skewed distribution of returns is the result of investors facing uncertainty, not just risk. When faced with risk, agents are able to make optimal decisions as they understand the distribution of outcomes. Under uncertainty, probabilities are unknown and optimal decision making is impossible. Innovation is an inherently uncertain process and excess profits are a reward for bearing uncertainty rather than just risk. Investing in these types of stocks means there is likely to be more losers than winners, regardless of how competent an investor is.

Figure 1: Example Return Distribution for a Basket of Early-Stage Tech Investments (Created by author)

A basket of mature companies is likely to have more normally distributed returns, where the median and average return are similar. Investors in these types of stocks are likely to have more winners than losers and the performance of any individual stock is less likely to dominate the performance of the portfolio.

Figure 2: Example Return Distribution for a Basket of Mature Companies (Created by author)

The distribution of expected returns has important portfolio management implications. Individual position weight limits introduce an implicit mean reversion strategy to the portfolio. Winners must be periodically sold and the capital reallocated across the rest of the portfolio. Early-stage technology investments are more likely to benefit from a buy and hold or even a momentum strategy. Rebalancing means that portfolio returns will be closer to the median of the individual position returns rather than the average, an undesirable situation when returns are highly positively skewed. Venture capital firms face a similar, although more extreme situation to ARK. They make a large number of small investments, most of which fail, but the strategy works because the occasional winner generates tremendous gains. These winners are held (or even added to), even if it means an individual holding grows to dominate the portfolio.

Figure 3: Example Returns for Portfolios of Stocks with a Buy and Hold or Rebalancing Strategy (Created by author)

Prior to 2021 ARK had a 30% cap on how much of each fund’s assets could be invested in a single security. This cap has since been removed, but ARK has shown a tendency to reduce a position’s weight at around 10-15%. This rebalancing means that for ARK to generate market-beating returns, they must be able to consistently pick winners from a universe of stocks that is likely to be dominated by losers.

Limiting an individual position’s weight could be considered prudent risk management and a competent manager may be able to add value by selling overvalued stocks and buying undervalued stocks. It is also questionable how much appeal an active ETF would have for investors if it ends up primarily invested in one stock due to gains in that stock. Investors could avoid management fees and achieve similar returns by directly investing in that particular stock.

During a normal market environment correlation between individual holdings may be relatively low as stocks trade on fundamentals. During a bubble, asset prices may become divorced from fundamentals though, causing correlations to increase as investors chase returns. This also occurs on the downside as investors become fearful and seek to avoid exposure to high-risk stocks. This can mean that under normal circumstances only a small percentage of the portfolio performs well due to the performance of the underlying businesses, but during a market pullback, the entire portfolio may perform poorly regardless of the performance of the underlying businesses.

This dynamic has been exacerbated by the fact that many of the stocks ARK has invested in are relatively small, with limited liquidity. ARK holds a substantial portion of the equity of a number of stocks and ARK’s buying/selling creates substantial pressure on stock prices. This is beneficial during a bull market as fund inflows create buying pressure on smaller stocks, driving prices up and increasing the fund’s returns, thereby attracting more inflows. If this process were to unwind though it could be devastating.

ARK’s universe of stocks is characterized by high uncertainty and large potential returns. This means that a relatively low percentage of stocks are likely to be long-term winners, but those that are should offer very large returns. To benefit from this, investors must be able to buy and hold winners, even as they come to dominate their portfolio. For a rebalancing strategy (where winners are periodically sold) to work, investors must be able to pick a relatively high percentage of winners. This is extremely difficult due to the large amount of uncertainty and could cause even above-average investors to achieve disappointing returns.