The illiquidity Trap
April 14, 2021
There is a corner of the FT that continues to do sterling work as financial journalists, having alerted us to, inter-alia, Wirecard, Greensill, Softbank, (especially with We Work but also some of the other egregious actions of the former Deutsche Bank traders) and now also Ark Investment Management, the active ETF fund house that has grown dramatically in the last few months (not coincidentally we suspect since founder Cathy Wood resolved her dispute with her minority owner/chief US distributor). To be clear, this is not to bracket Ark with the above list of ‘wrong ‘uns’, but it is nevertheless somewhat alarming to read this.
Essentially, for those unable to access the link, it points out that the second largest shareholding of the newly launched $700m Ark Space exploration and Innovation fund, at around 6%, is the 3D Printing ETF (ticker PRNT US) , of around the same size and also owned and managed by Ark. Thus 6% of one Ark fund is now owned by a different Ark fund. Sure, you can make the case that 3D printing is an important component of space exploration and that this is a diversified way of playing it, but this notion of cross holdings by funds raises the spectre of the Split Cap Investment Trust scandal of the early noughties when funds marketed as low risk turned out not only to have taken on significant leverage to boost returns but also where a so called magic circle of funds all had cross investments using that leverage to buy assets in one another. Leverage and concentration risk can appear to deliver risk free returns…so long as you don’t acknowledge they are risks.
So far therefore (not really) so good, but we have looked at the 3D printing fund before when discussing concentration risk and noted that in tracking a relatively small index, it is very heavily exposed to a couple of smaller cap stocks – albeit they are the largest weights in the index. Its biggest holding for example is ExOne, which has a market cap of around $700m and is up a mere 200% year to date – although the share price is literally half what is was two months ago. So a lot of volatility. Ark owns more than 10% of the company and a number of Japanese companies (who look to be Ark clones – they have a lot of managed accounts) also own meaningful amounts. Other holdings in companies like DDD or the French company MGI show a similar concentration of holdings, either as a large and illiquid % of the Ark funds or where ARK is the owner of a significant % of shares outstanding. In the Unit Trust world, having more than 5% of a fund in single stock or else owning more than 10% of the shares outstanding in a single company were (rightly) seen as red flags by risk managers – a lesson recently learned by investors in the Woodford Funds. Clearly not the case with active ETFs, even though they are directly available to private investors. See here for an interesting discussion about the perils of offering daily liquidity (which Unit Trusts and active ETFs do) while being invested in illiquid assets.
As an intriguing aside, the 3D printing fund is currently the largest shareholder in MGI as shown on the Bloomberg holdings data, having gone from zero reported at September 30th to 99,000 at the end of December and over 450,000 on the latest filings. Given that the average daily trade is around 5-7000 shares that is a pretty illiquid position and they presumably bought it up to and around the EUR60 level it hit in mid February. If only they had bought that single lot of 388,000 shares that went through on September 30th at 38 eh? The fact that the next day it opened at 42 before spiking to 48 would in no way have implied anyone was front running their trades.Obviously not. No, not at all.
Making Money from illiquidity also exposes you to the risk of liquidity mismatch, something else that the regulators ought to be keeping an eye on. To take a charitable viewpoint about small(er) cap funds, it is a helpful coincidence if start-up funds from a fund management company have either the direct support (ie capital) from one of the company’s larger flagship funds or when the larger fund is also a buyer of some of the same underlying stocks, especially if they are relatively illiquid. Knowing that there is a steady underlying bid for a stock significantly reduces its volatility risk as well as often providing a directional bias. Indeed, during the noughties there were entire hedge funds based around the strategy of knowing when the mega funds were buying/selling their first unit and, particularly, their last. As a result the illiquidity risk in small cap, which is one key source of return, is reduced by the presence of the larger fund, while the return remains intact. Even better if the holding is a large one in the smaller fund and a small one in the larger fund, the element of ‘support’ is relatively cost free and is a known explanation for why some of the smaller funds in the stable of any large investment house tend to have stunning and very marketable track records that fade as they get bigger (as well as often having a lot of insiders’ capital invested in them).
New and smaller funds definitely benefit from having a larger in-house fund at their back
This is not to say that this is the situation with the various Ark ETFs, rather to note that cross holdings can take a more dangerous turn when buying turns to selling – often, but not exclusively, associated with redemptions. Meanwhile, it does seem like the regulator ought to be having a look at whether the retail buyers of the Space exploration ETF understand that one of their biggest holdings is in an ETF owned by the same company and thus double fees and that this second fund in turn is exposed to some serious concentration risk in that they and their associated Managed Account clones (White label funds for other, mainly Japanese, investors) represent a large and highly illiquid ownership of a number of small cap, unprofitable tech stocks that are heavily weighted in the thematic benchmark that they are tracking. Hopefully the FT will keep an eye out at least.