Cathie Wood's Ark Innovation ETF May Be The Greatest Short Vehicle For The Incoming Tech Bubble Pop

May 6, 2021

(Note: A version of this article was published by HFI Research on February 27, 2021, and the firm continues to hold a short position in the name.)

This is by far one of my highest conviction short ideas. For those of you that know me well, I don't usually write-up short ideas. I only write about them when they are so blatantly obvious that they are begging for my attention.

In the case of Cathie Wood, I find myself amused, intrigued, and absolutely disgusted. The epitome of the ultimate bubble rider, Cathie Wood epitomizes what a go-go, momo, bubble tech stock investor acts like. For most people, she is hailed as the genius with the foresight to have bought and hold names like Tesla (TSLA) but to others she’s someone who was prescient (lucky?) enough to ride an insane bubble.

Like I said in my recent memo titled, “Trying To Convince Someone They Are In A Bubble Is Impossible.” We are living in the definition of what a bubble looks like. We have:

1. Massive retail participation,

2. 20-30 year time horizons to justify current valuation or in other words, outrageous valuations, and

3. a changing macro backdrop where inflation is pressuring interest rates higher.

As I have learned the hard way, bubbles can often last longer than you can remain sane, and in this case, we've seen the bubble tech stocks continue for the last 6 years. Until of course, the argument that low-interest rates justify insane valuation turns upside down.

Interest rates, the gravity of finance, are starting to turn, and the tide is shifting now against growth investors. Will investors keep paying for a 0.5% free cash flow yield in the hopes of receiving further capital appreciation, or will sobriety finally prevail, as it gets stronger with each price drop?

Based on everything I've researched about bubbles thus far, these things take time to pop. This classic bubble chart pattern is really the perfect way to explain how a bubble pops.

We are right now in the “denial” phase for most tech investors, and if you ask some of those investors how they feel about the market today, they will say something along the lines of, “yes, we were due for a correction, but I think that's a great opportunity to buy the dip.”

As a matter of fact, that's exactly what Cathie Wood is saying as recently as this week. Here’s the interview of her on CNBC:

And if you are willing to watch the entire video, you will note that she is talking about the autonomous market for Tesla, and how that’s an $8T industry.

🤦‍♂️

Now let's get to the meat of it all.

Why is ARKK a short?

Normally when you look at a short idea, you always have to ask the question, what's my downside? Can an event like Gamestop happen to something like ARKK? How can I maximize my returns and minimize downside risk?

Shorting is different than going long, because if you are wrong, your downside is unlimited, whereas your upside is limited. So the thought process is different.

Instead, you have to focus on the question: What's my catalyst?

In the case of ARKK, the catalyst is simply just the underperformance of ARKK. When I look at this short idea, I don’t necessarily need the catalyst to be that ARKK is dropping every day, I simply need it to stop going up.

Not going up is the same as underperforming in the world of money management. And when you stop outperforming, you are going to get redemptions.

Now for Cathie Wood’s, the launch of the ARKK ETF was a huge success. Daily reporting, transparent disclosures, and an amazing move in tech stocks have swelled the fund’s assets under management (“AUM”). As ARKK’s AUM rose, the fund kept piling into even more of its illiquid positions, which spurred further price increases and the ETF’s outperformance. More AUM followed, and the perfect flywheel was invented (or reinvented).

In a report written by Edwin Dorsey titled, "Will Ark Invest Blow Up?" He pinpointed all of ARKK’s illiquid holdings.

Now, this is a scary situation to be in. According to various investors who have tracked ARKK’s positions, the fund currently has ~43% of its portfolio invested in companies where it already owns a large stake, making the positions highly susceptible to short attacks.

If you review history, this has happened to funds like Long-Term Capital Management, Melvin Capital, Greenlight Capital, Pershing Squares, and most famously Julian Robertson's Tiger Capital.  Even a legend like Warren Buffett didn’t escape the wrath of the internet traders of 1999 when Berkshire Hathaway’s price was halved.

When you start underperforming (i.e., the stocks you own go down), investors will want to pull their money out, and since ARKK is structured as an ETF, the redemptions are real-time, which means ARKK will need to immediately sell positions. Since ARKK publishes its trades daily, traders will also hawk those positions to see which ones can be further attacked.  

Here’s the real kicker, as we watched tech stocks underperform last week, ARKK kept selling its liquid positions to meet redemption calls, while simultaneously buying the illiquid names. It’s likely that if ARKK didn’t support the illiquid holdings, the ETF’s performance would have weakened further, which could have resulted in further redemptions. The flywheel works in both directions.

So once the tech bubble pops, and the air starts to come out, ARKK will likely go into a death spiral. All of its positions, particularly the illiquid ones that ARKK holds in increasing concentration, will get targeted as traders smell blood. The fund may have to stop publishing trades daily, or sell its illiquid positions at steep discounts when redemptions kick into high gear. Either way, readers aware of this situation can take advantage.

Risks

The risk to this trade is that the bubble stocks continue to grind higher, and ARKK’s AUM outflow reverses. Inflows give the fund more time.

But as we will discuss below, that's why you can set-up the trade to take advantage.

How to trade this?

In my view, the best way to trade this is to take advantage of the lopsidedness of the options market.

Here are the January 2023 call strikes between 200 and 220.

Here are the January 2023 put strikes between 100 and 90.

As you can see, you can sell the 1 call option at 200 strike, collect ~22.50 in premium, while simultaneously using the call premium sold to buy a put contract at 100 for 18.50.

You collect $400 to short ARKK at $100. If ARKK ends up falling back to $30, then your profit would be $7,400 on the set-up.

The only way you lose is if ARKK starts to rally and gets close to the $200 strike, which would require a move of ~54%. It's certainly possible for such a thing to happen but given the recent price action and the redemptions already underway, it's a lower probability.

Now options trading is clearly risky and requires you to fully understand the issues before you make the trade. But the skewness in the options market combined with the possibility of further redemptions makes this one of the best short ideas in recent memory.

As investor redemptions grow, ARKK will have to keep selling its liquid positions, while holding onto illiquid ones making it more susceptible to short attacks. ARKK may eventually corner itself into a situation where there’s no way out, and could blow-up because of this.

Again, this is not a risk-free trade, it is a higher risk one and requires the bubble mania to pop. If so, ARKK may be one of the best vehicles to express this theme.

Disclosure: I am/we are short ARKK.