Ark's Flagship ETF Is Ill-Prepared for Future Risks: Morningstar

Morningstar initiated its first analyst rating on an ETF from Ark Investment Management with a warning about its biggest fund, the Ark Innovation ETF (ARKK), which has over $17 billion in assets.

The ETF, which like all actively managed Ark ETFs has a five-star rating based on past performance, was given a neutral rating by analyst Robby Greengold, who wrote that the firm is “ill-prepared to grapple with a major plot twist,” because it has only one portfolio manager, CEO Cathie Wood, who heads an “inexperienced team” and “lax risk controls.”

“Few features of its research team or process suggest ARK Innovation will continue to beat the Russell Mid Cap Growth Index on a risk adjusted basis,” Greengold writes.

The ETF aims for a minimum 15% annualized return over the next five years, which is double the annualized return of the Russell index since 2000, by investing in companies involved in artificial intelligence, blockchain, DNA sequencing, energy storage and robotics.

Cathie Wood’s Dominance and Ark’s ‘Unclear Analytical Edge’

“As ARK’s primary investment decision-maker who has established a ubiquitous media presence and enthusiastic following, Wood is essential to the firm’s continued success,” writes Greengold. He notes the firm’s director of research, Brett Winton, who would likely succeed Wood if needed, has no experience as a portfolio manager though nearly 15 years experience in the financial industry. Moreover, writes Greengold, “Many of the analysts supporting the funds’ research have come and gone, and most of the remaining nine lack deep industry experience.”

Greengold criticizes Ark’s analyst bench for lacking academic credentials beyond bachelor’s degrees and, for some, even a history of full-time work. He’s also uncomfortable with its crowdsourcing approach to research, outsourcing technical expertise to academics, entrepreneurs and former Ark analysts and inviting feedback on its research and investment ideas from individuals that follow the firm on social media.

“These features make the firm’s process of gathering and digesting information unique, but its analytical edge remains unclear in an industry that provides (for a fee) subject-matter expertise to advise shops that lack requisite technical know-how,” writes Greengold.

Wood would disagree. In her many public appearances, Wood celebrates the diversity and enthusiasm of the firm’s analysts and their experience coming not from the usual financial services professional and academic pipelines but from engineering, computer science and mathematics.

Their focus is on new and evolving technologies and innovative platforms that overlap and collaborate with one another, according to Wood. Autonomous taxis, for example, involve multiple platforms — robotics, energy storage and AI, Wood noted in a virtual conversation in December as part of a Goldman Sachs video series, “Insights from Great Investors.”

Greengold says other traditional financial firms’ analysts also collaborate and Ark’s analysts’ focus appear to be their own “information silos,” not unlike the framework that traditional financial firms use, which “could lead ultra-specialization and potential blind spots that better resourced firms wouldn’t miss.”

The firm’s scoring system for companies based on six inputs — a company, its people and culture, execution, barrier to entry, product leadership, valuation and thesis risk provides “little visibility  into the portfolio’s aggregate risk exposures” as well as their sources of its risks and returns, writes Greengold.

Lack of Risk Management

Greengold also criticizes Ark’s lack of risk management personnel to stress-test the portfolio risk exposures and estimate potential losses in the case of market or company crises, given its “lack of portfolio construction parameters” and concentration of assets.

Ark recently lifted restrictions on the size of its top positions for all its ETFs, which were already  quite liberal. The Ark Innovation ETF was the most concentrated of all U.S. funds in February, owning 10% or more of the floating shares of more companies than any other fund, according to Greengold. Tesla now accounts for almost 11% of ARKK’s assets after the ETF bought more shares when the stock’s price dipped in late February.

The Downside of Success

The success of the Innovation ETF raises its own risk. Its assets swelled tenfold over the 23 months ended Feb. 28, and its in small companies grew — stakes that will be difficult to sell “without impacting their stock prices,” writes Greengold. “Nimble execution is now tougher than before,” especially since its portfolios are disclosed to the market daily.

“Ark’s pursuit of disruptive innovators has merit, and its quest for big rewards may appeal to aggressive investors,” Greengold writes. “But its team of inexperienced analysts, go-with-your-gut risk management approach and bloated asset bases raise doubts about whether this fund’s outstanding historical results can continue.”