ARK ETFs and investor redemptions

This is really two comments. The first is about expectations:

–the flagship ARK ETF is Ark Innovation, ticker ARKK. Last year, according to my Yahoo Finance chart (I write this qualifier because my memory is the return was slightly different), ARKK gained +184%. This compares with an advance of +43% for NASDAQ and +18% for the S&P 500. The Dow, the ghost of Christmas past and kind of the inverse of ARKK, struggled to rise a tad less than 9%.

Yes, ARKK is a highly concentrated portfolio (the top ten holdings of last Friday made up 45%+ of its assets) and is focused on the most rapidly expanding parts of the world economy. On the other hand, it came close to tripling last year. It delivered something like 10x the return of the S&P and 5x that of NASDAQ. This, as the typical professionally managed portfolio struggled (as usual) to keep pace with its benchmark.

A burning question: what are the chances that ARKK can repeat its 2020 performance this year? Given my strong belief that investing (and life, for that matter) is a lot like baseball, my bet is that the business cycle-sensitive team will get a turn at bat in 2021 and may score a bunch of runs while secular growth sits on the sidelines. That’s the way the stock market always works, so why would anyone expect something different now?

I think that although some will always chase the flavor of the month, most mutual fund/ETF investors understand this and will remain with a competent manager. Also, all but the most recent purchasers will have substantial capital gains, which typically deter taxable accounts from cashing in.

So it seems to me that financial press fears of widespread redemptions in the ARK funds as/when they have a period of underperformance are way overblown.

My second thought is about redemptions from ETFs vs. mutual funds:

–if I hold shares in a mutual fund and want to sell them, I have my broker return them to the mutual fund company, which cashes the shares out at net asset value, which it calculates after the close of trading that day. The fund typically has a enough cash on hand to deal with ordinary redemptions, plus bank credit lines to use if need be.

If I hold ETF shares, on the other hand, and want to sell, my broker deals with an Authorized Participant (AP), who is basically a market maker who buys and sells the ETF’s shares during normal trading hours. The AP always knows what NAV is (from the stream of every-15-seconds exchange price updates), and makes a bid-asked spread around it. If there’s lots more selling of the ETF than the AP can find buyers for, the AP has the ability to return the excess to the ETF company in exchange for bundles of stock the ETF holds.

Strictly speaking, then, unlike a mutual fund, an ETF itself never has to sell holdings to raise cash–because it meets redemptions from APs by delivering stock the ETF holds instead. The AP, typically part of a big bank or brokerage firm, isn’t forced to sell the stocks it gets. If it does decide to sell, the AP isn’t under the same time pressure as a mutual fund. Finally, my observation is that in past times of great market stress, which is far from the condition we’re in now, the AP could easily be holding more stock than it would care to, if it bid for shares at around NAV. So the AP lowers the bid to the point where excess selling dries up. This does two things: it stops at least some selling, and it makes the reward for taking the risk of holding the ETF shares it does buy, or redeeming them for stock, more palatable.

This characteristic of ETFs has two consequences: the ETF doesn’t have to have a cash reserve to meet possible redemptions and it has less risk in running a concentrated portfolio than if it were a mutual fund.

A closing note: the financial press has advanced worries that if redemptions in concentrated ETFs/mutual funds become either high or protracted, the funds will sell their most liquid holding first, leaving “loyal” shareholders with illiquid dregs. It’s possible–in the sense of I can write a sentence describing this behavior and understand what it means–this could happen. But normal portfolio practice during a period of redemptions is to go to work immediately on selling illiquid positions, precisely to avoid the situation the press describes.

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