A great deal of attention these days is being focused on Cathie Wood’s ARK funds, particularly the flagship ARK Innovation ETF, which has $22 billion in assets. People are afraid that the illiquidity of the shares owned by the exchange-traded fund will cause it to blow up if too many investors try to get out of the fund at once. It’s an old Wall Street game to look for liquidity mismatches between funds and their underlying assets, but ETFs don’t work that way.
First, ARK is an actively managed ETF, which is kind of a strange creature. Only a handful exist, with the most successful focusing on such things as ultrashort duration bonds and money market instruments. Wood and her team of analysts pick stocks and add them to their ETF, just like any portfolio manager would. Those stocks show up in the daily create/redeem baskets that authorized participants use to create or redeem shares of the fund. There is nothing unusual about this, except that the estimated cash component needed to meet redemptions will vary as trades are made on an intraday basis at the fund level.
If you want to sell shares in an open-end mutual fund, you send a redemption order to the fund, which then has to raise cash to meet the redemption order by selling certain assets. The decision of what assets to sell is complex. Sometimes it is easier to sell more liquid assets to raise cash, and sometimes there are less desirable assets that the manager has been looking for an excuse to dump. Regardless, a redemption order represents an immediate demand for cash, which must be met at the end of the trading day.
If you want to redeem shares of ARK, you simply sell the shares in the open market. A market-maker will buy the shares and hedge them by selling the underlying basket of stocks owned by the ETF. It has been widely reported that the stocks owned by ARK are not very liquid, that the ETF represents a huge percentage of trading volume in these stocks and that ARK has very concentrated positions in each of the stocks. The only thing that matters here is the liquidity; if the basket is difficult to trade, market-makers will widen out their bid-ask spreads to compensate for the execution risk.
If a lot of people decided to sell shares ARK all at once, it would certainly drive the price of the ETF down a lot, but that is true of pretty much any stock. The ETF structure is unbreakable. There have been some comparisons drawn between ARK and the well-known iShares iBoxx High Yield Corporate Bond ETF, and there have been times—like last March—when the latter traded at a significant discount to its net asset value because it simply could not sell the bonds it held fast enough.
That sort of thing is unlikely in the stock market, no matter how illiquid the stocks are, but if it happens, the same thing will happen to ARK—it will trade at a discount, and function as a price discovery mechanism, telling you where the NAV of the ETF will be in the future. In this way, the ETF structure is superior to an open-end fund. If an open-end fund is flooded with redemptions, it must raise cash, and typically sells liquid assets in lieu of illiquid assets. If the redemptions continue, the issuer will be forced to “gate” the fund until it can sell assets to meet redemption requests. ETFs don’t gate liquidity. They will continue to trade, albeit at perhaps a discount to NAV, but you will be able to get out.
If there is a concern here, it’s not about the ETF, but the wisdom of Wood’s investment strategy. Some see similarities with the old Janus Twenty mutual fund, a highly concentrated tech mutual fund that was a late 1990s favorite, or even the Munder Net Net Fund, which went from $10 million in assets to $12 billion to zero in the span of four years. Wood seems to think that growth and innovation investing is a strategy that will transcend market cycles rather than just a passing fad. If she is wrong, ARK could meet the same fate as Janus or Munder. But that is different than questioning the durability of the ETF structure.
Jared Dillian is the editor and publisher of The Daily Dirtnap, investment strategist at Mauldin Economics, and the author of Street Freak and All the Evil of This World. He may have a stake in the areas he writes about.