Aggressive bets going well a little too long, star cult, and no risk management are the perfect recipe for disaster.

The ARK Innovation fund has brought active management to the center of the ETF world and catapulted its manager Catherine Woods into the front row of global money management. Indeed no other fund has made headlines over the past two years, just like this product launched with only $4m in 2014. Unfortunately, during this short period, it has also demonstrated beautifully what's way too often with active asset management and especially with thematic investments.

Obviously, analyzing a failure with the benefit of hindsight is not a particularly challenging task. Still, our clients know that we have always taken a cautious (and admittedly sometimes cynical) stance towards concentrated stock picking strategies and thematic hypes. For this reason, we think it is legitimate to sin for once and take the performance of the ARK Innovation ETF as an opportunity to express these warnings again.

Catherine Woods founded ARK Invest in 2014 after her idea to wrap portfolios of particularly innovative corporations into ETFs failed to resonate with her then employer, Alliance Bernstein.

Its flagship ARK Innovation fund started with an initial investment of only $4m and took more than two years to reach the $10m level. Business picked up for ARK Invest when its initially lagging performance picked up in 2017 and 2018, but inflows ebbed out as the fund underperformed the NASDAQ in 2019. By the time markets crashed due to the first wave of Covid19, the track record of ARK's innovation fund was everything but great. As of mid-March 2021, the fund had posted a cumulative return roughly equal to that of the NASDAQ while having experienced a 9% higher volatility.

The rather humble start of ARK's flagship fund should have served as a warning signal. The chart above doesn't display stock-picking skills but rather an incredible amount of luck. With the Covid19 driven lockdowns, ARK's bets started to benefit from a spectacular rally that would unlikely have occurred without the pandemic. While such home runs are hard to control, the risk usually is, and as Wood's former supervisor at Alliance Bernstein pointed out, this is a topic not particularly well understood by her.

In total, the fund's clients lost more than $1.3bn

Sadly, this has severe consequences for end investors who bought the fund. Based on the price and assets under management of ARK's innovation fund, we can estimate its in- and outflows, and as the chart below shows, the balance is negative as of today. Due to the small size of the fund pre-Covid, only a fraction of ARK's clients benefited from its stellar performance in 2020. When its NAV reached the current level for the first time, it had collected a total of $4.2bn. Its net inflows have now increased to $14.4bn, implying that more than 70% of its investors are underwater. In total, the fund's clients lost more than $1.3bn or 8.5% of the current assets under management.

Since inception, this translates into a money-weighted return of -5.6% compared to +24.3% for iShares NASDAQ 100 ETF. In other words, ARK's innovation fund has destroyed a tremendous amount of value.

The patterns observed here are not unknown. As the Financial Times pointed out, it is, in fact, a common phenomenon in the hedge fund industry that "a manager records big gains in the early years on a small asset base. Investors chase the performance, and assets pour in. Returns plummet." However, ARK stands out in this context precisely because it is not a hedge fund.

We explained previously why we think that "passive" can be a misleading term for ETFs. Still, there is no doubt that the ETF structure has for the longest been associated with highly diversified, cost-efficient, and rules-based strategies. In a way, Catherine Woods captured the ETF structure and used it for a product that resembles the opposite of all this while targeting unsophisticated retail investors through aggressive use of social media.

While early ETFs offered broad-based portfolios at low cost, in later years, issuers began launching thematic ETFs that hold niche portfolios and charge high fees.

Ben-David et al. 2020

ARK Invest managed to seize a unique position in the Asset Management industry through a combination of luck and clever marketing; it eventually confirms an observation we have made many times: Aggressive bets going well a little too long, star cult, and no risk management are the perfect recipe for disaster.

The saga also contains lessons for the broader thematic spectrum. A great marketing machine is at work, producing buzzwords such as Circular Economy, Internet 4.0, or Future Mobility. To be fair, many asset managers in the space approach the topic more professionally than ARK and, most importantly, have better risk management in place. Nevertheless, as Ben-David et al. showed in their December 2020 NBER working paper, "new thematic ETFs hold attention grabbing stocks (high past performance, media exposure, and sentiment). After launch, these securities underperform as the hype around them vanishes".

So when you get the next call from your advisor telling you to invest in the Meta Verse or Clean Energy, keep in mind that you are very likely to be among the majority that joins the party too late.