Cathie Wood Is Wall Street’s Hottest Hand. Maybe Too Hot.

 While the world has been mesmerized by the crazy gyrations of a handful of stocks over the past couple of weeks, Cathie Wood has kept on minting money for her investors as few money managers ever have.

Ms. Wood is chief executive and chief investment officer of ARK Investment Management LLC of New York, which is not only today’s hottest fund manager but one of the hottest performers of all time.

Such success for other managers, however, has often carried the seeds of its own undoing. It’s almost inevitable that when funds get too big, too fast, they can’t sustain their performance.

That’s partly because all that money makes it hard for fund managers to maneuver as nimbly as they did when they were small. Copycats mimic their every move, and it’s a lot easier to sell a few shares of a stock on the way up than it is to sell oodles of them on the way down.

 

ARK runs five exchange-traded funds for which Ms. Wood and her team of 11 analysts and portfolio managers actively invest in companies they believe will change the world through what they call “disruptive innovation.”

Since its launch in October 2014, ARK Innovation, the firm’s largest fund, has delivered an average return of 39% annually. Had you invested $10,000 at the fund’s inception, it would have been worth more than $78,000 this week; the same stake in the S&P 500 would have amounted to less than $22,000.

Money chases performance. ARK managed a total of $11.4 billion at the end of March 2020. By year end, that had swollen to $58.2 billion.

Among the earliest institutional investors to buy both Tesla Inc. stock and bitcoin, Ms. Wood is an eloquent evangelist for assets she believes are on “exponential growth trajectories.”

Already, Ark has to contend with mimicry. So far, a smartphone app and at least three websites have sprung up that purport to track Ark’s daily trades. In reddit’s sometimes raunchy online WallStreetBets forum, members call Ms. Wood Cathie Bae (short for “babe” or “before anyone else”), and traders talk about buying ARK’s favorite stocks and what the firm might invest in next.

This year, stocks are lifting off even before ARK buys them. On Jan. 13, the firm filed a prospectus to launch a new fund, ARK Space Exploration ETF. Although the fund hasn’t yet received regulatory clearance, satellite and other space-related stocks shot up 8% to 10% the next day.

Size also can become an impediment. When you have millions of dollars, you can easily invest in a few small companies. Once you have billions, you may have to spread investments across more and bigger companies; otherwise, your trades could wreak havoc on your holdings. Many fast-growing asset managers have changed their investing style, incurred much higher trading costs or simply suffered a severe decline in performance.

ARK is already a big owner of some small stocks. At Israeli biotech company Pluristem Therapeutics Inc., with a total stock-market value of $219 million, ARK holds 15.5% of the shares outstanding. That’s three times as much as all other institutional owners combined. At a French biotech, Cellectis S.A. , with a $900 million market value, ARK owns 11.5%—more than the next 11 largest holders combined.

Although those two positions make up barely 0.5% of ARK’s total assets, they reflect the firm’s style.

According to FactSet, 43.5% of ARK’s total equity holdings are in stocks of which the firm owns at least a tenth of all shares outstanding. At Vanguard Group, by contrast, only 9.7% of total equity positions are in such concentrated holdings.

If ARK ever needs to sell any of those holdings, who will buy in enough bulk to keep prices from collapsing?

In an interview, Ms. Wood says that as markets rise, ARK diversifies into larger companies. They form a kind of war chest that ARK can tap into “during downturns, when our less-liquid stocks will be hit disproportionately, giving us better bargains,” she says. In other words, ARK counts on being able to sell some big stocks to buy smaller ones when those become even cheaper—as it did successfully during last year’s severe bear market.

Also, many of ARK’s smaller companies are issuing additional shares, “and it is with our encouragement sometimes,” says Ms. Wood. “We want our companies to invest aggressively today,” because ARK believes these businesses should be financing their unparalleled opportunities for future growth.

As a result of new stock offerings, those companies’ shares are becoming more liquid over time, she says.

What might happen if the same investors who flung billions of dollars into ARK’s funds over the past year yank the money back out?

“Not concerned about it,” says Ms. Wood. “I mean, Tesla a year ago was 10 times smaller than it is today.” (Tesla Inc.’s total market value was $77 billion at year-end 2019; this week, it exceeded $810 billion.) “That’s telling us, reinforcing our sense, that the market is beginning to understand the exponential growth opportunities out there,” which will create ample liquidity over time, she says.

Even so, I worry about ARK’s outsize positions in relatively few stocks, where it is often the biggest boat in a small pond.

At my request, Elisabeth Kashner, director of funds research at FactSet, analyzed the liquidity of ARK’s holdings. She calculates that if investors sold enough shares of ARK Innovation ETF to cause a $1 billion redemption, that would require 14.5% of the recent trading volume of its underlying holdings, on average, to change hands. For Vanguard Total World Stock ETF, by comparison, a $1 billion block sale would involve an average of only 0.6% of total trading volume in that fund’s stocks.

“Any selling of this kind is likely to be on a significantly higher-than-average volume day” in ARK’s holdings, says the firm’s chief operating officer, Tom Staudt. So ARK’s trades would likely be less of the resulting market-wide total than FactSet’s numbers imply, he says.

Given ARK Innovation’s massive $25 billion in assets, “it is reasonable to worry about the market impact of $1 billion exiting the fund in a single day,” says Ms. Kashner. If a redemption of that size occurred, she says, “downward pressure on the fund constituents would be nearly inevitable.”

 

Is size a boon or an impediment for a fund manager? Join the conversation below.

An old Wall Street proverb warns that it can be hard to get out of stocks when markets go bad: “Liquidity is there only when you don’t need it.”

Another warns, “When you have a few shares of a stock, you own it, but when you have lots of shares, then the stock owns you.”

Write to Jason Zweig at intelligentinvestor@wsj.com