Morningstar - Q2 2021 - 47

Reasonable Doubts
ARK Innovation ETF could be thrown
for a loop.
ARK

Robby Greengold

Thematic-investing specialist ARK Investment
Management has been in tune with the
market's unfolding narrative in recent years, but
its lone portfolio manager, inexperienced
team, and lax risk controls make it ill-prepared
to grapple with a major plot twist. Its
flagship strategy, ARK Innovation ETF ARKK, earns
a Morningstar Analyst Rating of Neutral.
ARK invests across five technology platforms that it
thinks will revolutionize how economic sectors
across the globe operate: artificial intelligence,
blockchain, DNA sequencing, energy storage, and
robotics. ARK Innovation's portfolio is top-heavy,
makes huge industry bets, and has historically
invested in publicly traded companies of virtually
every size. It embraces money-losing companies
so long as they're aggressively investing to
exceed their already high growth expectations.

The firm invests only in companies it thinks
will gain 15% or more annualized over the next
five years. That hurdle is roughly double

ARK Innovation ETF ARKK
Morningstar Analyst Rating

‰

Process

Below Average

People

Average

Parent

Average

Morningstar Category

Mid-Cap Growth

Expense Ratio

0.75%

Source: Morningstar Direct.

the annualized return of the Russell Mid Cap
Growth Index-the benchmark for the fund's
Morningstar Category-since 2000. So
far so good: ARK Innovation famously gained
150% in 2020 alone. The question is whether it
is likely to continue to outperform.
Personnel Problems
ARK's main draw is its founder, chief executive
officer, and portfolio manager Cathie Wood,
who launched the firm in 2014. Wood honed her
thematic-oriented process at AllianceBernstein
from 2001 to 2013, where she ran several
high-volatility strategies similar to this one. During
her 12 years at the helm of large-growth
separate account AB MA Strategic Research, its
before-fee total returns comfortably outpaced
the Russell 1000 Growth Index but lagged on a riskadjusted basis. She also managed two growthoriented mutual funds that underperformed
their bogies on her watch, in risk-adjusted and
absolute terms.

Wood has established an enthusiastic following
as ARK's primary investment decision-maker,
and she is essential to the firm's continued
success. Director of research Brett Winton would
likely succeed her if needed, but his nearly
15 years of industry experience include none as
a portfolio manager. Exacerbating that keyperson risk is a lackluster research team: Analysts
have come and gone, and most of the current
nine lack deep industry experience.
ARK outsources much of the technical expertise
to " theme developers " -including academics,
entrepreneurs, and former ARK analysts-who
donate their time. It also invites feedback
from individuals following the firm through social
media. This process of gathering and digesting
information is unique, but its analytical
edge remains unclear.

The firm has no risk-management personnel
and views the subject almost exclusively through
the lens of a scoring system that monitors
six inputs to a stock's investment thesis: culture,
execution, moats, product leadership, valuation,
and thesis risk. This is a solid foundation for
bottom-up research-most investment teams use
a variation of this-but it provides little visibility
into the portfolio's aggregate risk exposures.
Flying Blind
ARK has few portfolio construction parameters. It
has said it will generally invest no more than
around 10% of ARK Innovation's assets in a single
company (it has adhered to this guidance) and
no more than half of that fund's assets in a single
technology. To be sure, ARK makes no promise
to diversify its portfolios, and it tells investors to
expect volatility. But even a high-octane strategy
like this one should be cognizant of the risks
embedded in its portfolio and managed to a
definable risk tolerance. It seems not to be. Indeed,
on March 29, the fund removed prospectus
language limiting the size of its top positions and
its ownership percentage of individual companies'
shares outstanding.

Over the 12 months through February, the firm's
total assets under management leapt to roughly
$80 billion from less than $12 billion. As its
size has swelled, ARK Innovation's portfolio has
become less liquid and more vulnerable to
severe losses. (See " ARK Pushes Capacity Limits
of ETFs, " Page 20.) Without risk-management
professionals to stress-test the portfolio's
risk exposures and gauge worst-case scenarios,
the team is poorly positioned to prepare
and react.
The firm is shareholder-friendly in some ways.
It has developed its product lineup thoughtfully
by maintaining its focus on the handful of
innovation platforms and underlying technologies
it thinks have longevity, and its ETFs are costcompetitive with actively managed rivals.
But few features of its research team or process
suggest ARK Innovation will continue to beat
its category index on a risk-adjusted basis. K
Robby Greengold, CFA, is a strategist for Morningstar
Research Services LLC.

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Morningstar - Q2 2021

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