Fund managers that skyrocket to historic outperformance may face problems as they gain scale
Fun fact: Notorious B.I.G. never actually said “Mo Money, Mo Problems” in his iconic hit.
The song, arguably the most famous among those in his posthumously released album Life After Death, described the harsh reality that money and success could breed problems in the rap world. Of course, we can say the same in pretty much any context – and that includes the world of investment funds.
Taking ARK Investment Management as a prime example, the Wall Street Journal recently elaborated on how managers at the helm of funds that get too big, too fast can find it difficult to sustain their performance.
“Since its launch in October 2014, ARK Innovation, the firm’s largest fund, has delivered an average return of 39% annually,” the Journal said. The firm managed a total of US$11.4 billion at the end of March 2020, and by the end of the year had total AUM of US$58.2 billion.
Problems usually come with the territory of having a large and successful fund, the first of which is that others may attempt to duplicate its strategy. In ARK’s case, those have come in the form of a smartphone app and at least three websites claiming to track the firm’s daily trades. The notorious WallStreetBets forum includes Reddit users who discuss buying ARK’s favoured stocks and speculate on the firm’s next targets.
Another problem is that if the managers of a multibillion-dollar fund aren’t careful, the trades they make could dramatically impact their holdings’ market performance. To avoid this risk, managers may have to change their style by spreading investments across a bigger set of large companies.
Cathie Wood, the CEO and chief investment officer of ARK, told the Journal her firm diversifies into larger firms during rising markets, which they can sell with relatively little risk “during downturns, when our less-liquid stocks will be hit disproportionately, giving us better bargains.” She added many of the smaller companies in ARK’s portfolios are issuing additional shares, some at the firm’s encouragement to “invest aggressively today” to pursue their unparalleled future growth opportunities.
ARK is also noteworthy for its outsized and relatively concentrated holdings of stocks in which it is usually the largest investor in a small market. Analysing the liquidity of ARK’s holdings, Elisabeth Kashner, director of funds research at FactSet, found that a US$1-billion redemption of ARK Innovation ETF shares would require 14.5% of the recent average trading volume of its underlying holdings to change hands. In comparison, a US$1-billion redemption from the Vanguard Total World Stock ETF would necessitate just 0.6% of total trading volume on average in that stock’s funds.
But according to Tom Staudt, ARK’s chief operating officer, a redemption at that scale would likely happen on a “significantly higher-than-average volume day,” in the firm’s holdings, which would likely soften the market-wide impact of investors’ pulling out.
Still, Kashner has reservations. “[I]t is reasonable to worry about the market impact of $1 billion exiting the fund in a single day,” she said. Pointing to the US$25 billion AUM that the ARK Innovation fund currently holds, she said if such a redemption were to occur, “downward pressure on the fund constituents would be nearly inevitable.”