This article was originally published at the Humble Dollar
Cathie Wood's ARK Innovation ETF (NYSE:ARKK) was the toast of the investing town in 2020 and early 2021. The star portfolio manager picked one winning stock after another—stocks that benefited as much of the world shifted to work-from-anywhere.
Like so many other hot funds, her time in the sun didn’t last. After Wood’s flagship ARK fund returned more than 150% in 2020, plus another 25% to start 2021, the bubble finally popped last February. The peak-to-trough decline was 57.6% through Jan. 31.
ARK Innovation is an actively managed exchange-traded fund (ETF). Most ETFs passively track a market index. But as ETFs ballooned in popularity, some portfolio managers got crafty and opened active ETFs. An active ETF works like an actively managed mutual fund, with portfolio managers betting on stocks they think will outperform the market.
Active ETFs have some notable advantages over regular mutual funds, including potentially lower fees, effectively no investment minimum, and the ability for investors to buy and sell them throughout the trading day rather than waiting for the 4 p.m. ET market close, as happens with mutual funds. But perhaps the biggest benefit is the favorable tax treatment that the ETF wrapper offers. By contrast, regular actively managed mutual funds often make large taxable distributions to shareholders.
Still, relatively little money is allocated to active ETFs. According to Morningstar, they account for just 3.5% of the $6.6 trillion ETF market. As we’re now discovering with ARK Innovation ETF, maybe that’s a good thing.
How do active ETFs work? As with index ETFs, each active ETF has both a share price and a net asset value (NAV), which is the value of the fund’s portfolio figured on a per-share basis. To keep those two in line, there’s a mechanism whereby “authorized participants”—designated institutional investors—can exchange shares of the ETF itself for the underlying securities owned by the ETF and vice versa.
Everybody knows what an index ETF owns—it’s the securities in the fund’s target index—but active ETFs use more complicated systems to avoid immediately disclosing their holdings and thereby running the risk that investors will front-run their trades. Still, in essence, all ETFs allow an arbitrage process that keeps an ETF’s shares close to its NAV. This arbitrage process leads authorized participants to buy ETF shares on the open market when they’re at a discount to NAV and sell when they’re at a premium, thus closing the gap between the two. Still, even with this mechanism, during volatile times, wide gaps can open up between an active ETF’s share price and its NAV.
Maybe more important, there’s a major flaw with active ETFs. Nothing stops a massive influx of new dollars into a recently hot fund. In fact, because ETFs can be bought and sold throughout the day, it’s almost too easy for performance-chasing investors to pile into a hot fund. By contrast, regular mutual funds have the option of closing to new investors should their asset base grow too large.
Why would a mutual fund company—which makes money if it manages more assets—turn away investors? The bigger a fund gets, the harder it becomes to generate good performance. A $50 billion portfolio might have an average position size of $1 billion. That means that, even if a manager identifies, say, a $200 million market-cap company with great prospects, owning that stock just won’t make much difference to the fund’s performance, even if the manager buys 5% of the company’s shares.
Right now, mutual funds like Fidelity Growth Company (FDGRX) and Vanguard Capital Opportunity Fund (VHCAX) are closed. Analysts argue that even more mutual funds should be shuttered to new investors.
But when it comes to ETFs, closing isn’t an option. New shares are created on demand, whether a fund wants that or not. That’s a problem because an active ETF—like Wood’s ARK—almost inevitably attracts performance-chasing investors if it posts stellar returns. And all too often, those investors turn up just as performance is peaking.
Result: You get what’s called a behavior gap—a sharp difference between a fund’s time-weighted returns and its dollar-weighted results. ARK’s time-weighted returns were off the charts in the years leading up to its early 2021 peak. But many investors in ARK have endured sharp losses because they piled in just as the fund’s share price was topping out, and the result has been rotten dollar-weighted returns.
Performance chasing can, of course, happen with index ETFs and mutual funds, especially those that track more narrow market sectors. Don’t want to suffer a behavior gap of your own? Stick with index mutual funds and ETFs—those that offer broad market exposure.