This story appears in the December 28, 2014 issue of Forbes. Subscribe
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Each week Cathie Wood, founder and CEO of startup Ark Investment Management, gathers her six stock-picking analysts (five twentysomethings and a fiftysomething former filmmaker) for a brainstorming session at its offices in New York City. The freewheeling discussions cover such holdings as Tesla, Netflix, Athenahealth, Autodesk, Illumina and Salesforce.com and is punctuated by Wood's characteristically out-there predictions. "I think Oracle is toast, I really do," she declares at one.
During the two-hour sessions the group sits in a conference room--a departure from their normal practice of working at shared standing desks in an open workspace, with the 59-year-old Wood on her feet in the middle. But this is no closed-door caucus. One week a local tech exec drops by. Another, an engineering professor dials in. And while none has actually shown up, even competing money managers are welcome.
That's because Wood can't hide her stock picks, and doesn't want to. This fall Ark launched four actively managed exchange-traded funds built around themes: Industrial Innovation (ARKQ), Web X.0 (ARKW), Genomic Revolution (ARKG) and Innovation (ARKK). Like other ETFs, Ark's must disclose their holdings daily instead of quarterly, as traditional mutual funds do. While BlackRock, the world's largest money manager, unsuccessfully sought Securities & Exchange Commission approval to run a managed ETF exempt from daily disclosure, Wood is happy to put her holdings out there. In fact, anyone can sign up to get an e-mail every time she makes a trade--usually a few times per week in each fund.
A clever way for a tiny startup, managing just $26 million, to 'generate buzz'? Sure, but Wood also has sound reasons for her choice. ETFs are cheaper to operate, particularly for a small outfit. (Ark's funds charge an annual expense ratio of 0.95%, compared with an average of 1.24% for open-ended, actively managed funds, according to Morningstar.)
More important, ETFs avoid much of the tax drag of traditional mutual funds, which must pass through net realized gains to their holders annually. That's painful for investors who hold a fund outside of a tax-deferred retirement account. (During the early stage of the bull market, funds used carryover losses from the financial crisis to offset realized gains; this year more will be distributing big taxable gains to their holders.)
Taxable gains are a far bigger problem for actively traded funds, with their higher portfolio turnover, than for index funds, so the ETF tax advantage could be even greater for managed funds. Yet less than 1% of the $1.9 trillion invested in ETFs is actively managed, and much of the active sliver is in Pimco bond funds.
Mammoth BlackRock may fear that with daily disclosure traders would front-run its stock buys. But for tiny Ark, disclosure is a desirable feature, not a bug. "We are quite happy to have company joining us on the same side of the trade," Wood says, noting that she sees transparency as a way to get her sometimes controversial picks noticed as well as to lure younger investors.
Wood's buttoned-up wardrobe, thick-rimmed glasses, pale-pink nail polish and airy, country club voice can't conceal her bomb-throwing bent. As an undergraduate at the University of Southern California she found an early and lifelong mentor in supply-side economist Arthur Laffer, who sits on Ark's advisory board. As a 25-year-old analyst she called the end of the 1970s bear market while most on Wall Street were still running scared, sending her employer, Jennison Associates, on a long run of outperformance. Later, as a newspaper stock analyst, she got a front-row view of an industry disrupted and decided she'd rather put her money on the disruptors.
After 18 years at Jennison, Wood ran her own hedge fund for three years before landing at AllianceBernstein in 2001. There, as chief investment officer for thematic portfolios, she managed nearly
$6 billion at one point.
The idea for a family of actively managed ETFs came to Wood in August 2012, she says, when her three kids were all away and, amid the unfamiliar quiet, she got to thinking: "I have been watching disruptive innovation for my entire career--why don't I help my own sector along?"
Wood left AllianceBernstein in June 2013 on what she says were cordial terms after the firm passed on building out her ETF vision. While the firm won't comment, higher-ups there may have also tired of the roller-coaster ride produced by Wood's big bets. Under her, AllianceBernstein's Strategic Research portfolios returned 45% in 2009, versus 26% for the S&P, but lost 14% in 2011, when the S&P returned 2%. During her 12 years at AllianceBernstein she produced an average annualized return of 5.6%, compared with the S&P 500's 4.2%, Morningstar reports.
Risk-adjusted return is obviously another matter. Even Wood acknowledges her style isn't for the faint of heart and shouldn't make up the core of a typical investor's portfolio. (She, on the other hand, has all of her personal stock holdings in her picks.)
Wood is unapologetic about her bold investing style. To the contrary, she argues that since the market crash of 2008 active managers have become too timid and obsessed with matching some benchmark index every year, guaranteeing that they'll underperform that index once their higher fees are taken into account. Only 16% of the assets in Ark Innovation overlap with the S&P 500--13% if you strip out Apple.
A fan of Clayton Christensen's idea of disruptive innovation, Wood looks for companies building new technologies or ways of thinking, including those that may, in her view, have "fallen through the cracks" because Wall Street stock analysts are organized by industry. Is Athenahealth a technology stock or a health care stock?, she asks rhetorically to demonstrate her point, and answers, "It's both." Is Tesla a battery manufacturer or an automaker? Is Amazon a technology firm or a retailer?
Wood latches on to themes and finds stocks she thinks will win big from them--regardless of current P/Es or industry. Example: She figures that 10% to 20% of the country's annual $3 trillion in health care spending is wasted or at least spent inefficiently. That creates a huge opening for Athenahealth, which puts medical health and billing records in the cloud. It has a P/E of 100 times forward earnings and is the largest holding in Ark's Web X.0 fund.
Among the largest holdings in Ark's Industrial Innovation and Innovation funds is 3-D printer maker Stratasys. While down 30% year-to-date the stock is up nearly 500% over the last five years. Wood still likes it for two reasons, one being its acquisition strategy. "They have made very strategic rifle-shot acquisitions versus other companies that are serial acquirers," she says in a not-so-veiled dig at more consumer-focused, and therefore better-known, 3D Systems. The second and more fundamental reason she likes Stratasys is that huge amount of wasteful medical spending. She believes that 3-D printing will dramatically reshape manufacturing, allowing consumers to customize not just trinkets but also hearing aids, dentures and prosthetic limbs.
Ark holds its share of popular stocks, but Wood has her own take on them and why they're worth their lofty P/Es. Google is a top-five holding in the Industrial Innovation fund, in part because she likes its driverless cars.
Yet despite her focus on new technologies, Wood paints herself as a stock-picking throwback. "We know the managements. We know the financial statements. We know how they are disrupting the world in some way, shape or form. We take a point of view," Wood explains. "It's classical investing. This is what the masters did when I first started in the business."
As for her own industry, Wood predicts that managed ETFs won't be a novelty for long. "As a student of disruption I always look at the tipping point. Certainly in any consumer product or service, if something heads toward 20%, it usually takes off," says Wood, pointing out that ETFs account for 12% of the $15.8 trillion mutual fund industry. "I think we are hitting a tipping point."
Whether those managed ETFs will be transparent, however, isn't yet clear. A few weeks after nixing BlackRock's plans, the SEC gave Eaton Vance approval to offer a new structure--exchange-traded managed funds, or ETMFs--without disclosing holdings. The SEC determined these hybrid funds did more than BlackRock's blind trust model to make sure funds traded near their underlying value.
Robert Goldsborough, a Morningstar analyst who covers primarily passive strategies, has been watching Wood and Ark with interest. "Not being concerned about the transparency, it makes her unique," he says. "It is safe to say that, assuming Cathie does her research right, there is a real opportunity for her, because there is no one else providing this kind of exposure."
