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Fund manager Cathie Wood became a superstar in 2020, after her ARK exchange-traded funds earned some of the highest returns in history.

So far this year, ARK Innovation, the largest of Ms. Wood’s ETFs, is down more than 15%. Over the past 12 months, it has underperformed Invesco QQQ Trust, which tracks the technology-dominated Nasdaq-100 index, by a startling 65 percentage points.

What’s happened at ARK is a counterblast to the belief that ETFs are superior in every way to mutual funds. Over the past decade, investors have been stampeding into ETFs—which are, on average, much cheaper and more tax-efficient than mutual funds. ETFs have one critical flaw, however: They can get too big too fast, and nobody can stop it.

Nearly all professional investors admit—at least in private—that success carries the seeds of its own destruction. It’s a lot easier to rack up giant gains with a small fund than with a big one.

A mutual fund can mitigate this problem by closing to new investors, shutting off the inflow of cash. Over the years, when hot new money threatened to bloat mutual funds to unwieldy size, such firms as Fidelity, T. Rowe Price and Vanguard closed some of them until markets cooled off.

That way, managers weren’t forced to buy stocks they wouldn’t ordinarily touch—and investors didn’t pile in right before performance tanked.

In my opinion, not nearly enough mutual funds have closed to new investors—but at least they could.

Unlike mutual funds, however, ETFs generally don’t close to new investors. The ability to issue shares continuously is what keeps the price of an ETF trading in line with the value of its holdings.

So ETFs almost never limit their own growth. That presents a paradox: The better a portfolio performs, the bigger it will get—and the more likely it is to end up doing worse. That isn’t true for market-tracking index funds, but it is for just about any fund that seeks to beat the market.

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Seldom has anyone evaded that iron law of investment management—not even Warren Buffett himself.

When Berkshire Hathaway was small, “we needed only good ideas, but now we need good big ideas,” Mr. Buffett wrote in early 1996. “Unfortunately, the difficulty of finding these grows in direct proportion to our financial success, a problem that increasingly erodes our strengths.”

Since writing those words, Mr. Buffett has beaten the S&P 500 by an average of roughly half a percentage point annualized—far from the towering gains he racked up when Berkshire was much smaller.

What about ARK? The firm grew so big so fast that it quickly ended up owning large percentages of many of its holdings. That could limit its ability to trade them without adversely affecting the price, says Corey Hoffstein, chief investment officer at Newfound Research, an asset-management firm in Wellesley, Mass.

When a fund has to trade large blocks of stock, that can inflate their prices when the fund buys and crush their prices when it sells. Those moves can hurt returns.

“You can end up with a strategy and structure mismatch,” says Mr. Hoffstein. “The ETF might have been a perfectly fine structure when ARK was smaller, but there comes a point when the structure can become a drag on the strategy.”

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ARK, which declined to comment, has said that its funds will be able to “scale exponentially” as its favorite industries continue to grow. That means, the firm contends, that it could handle vastly more than the $54.7 billion ARK managed as of Dec. 31.

Ms. Wood has also argued that the stocks of ARK’s innovative companies have fallen so far that they constitute “deep value” bargains that could deliver average returns of 30% to 40% annualized over the next five years.

Be that as it may, the inability of ETFs to keep out hot money causes a problem no one can dispute: bloodcurdling losses for investors.

Here’s how that happens.

In its first two full years, 2015 and 2016, ARK Innovation gained less than 2% cumulatively. Then it took off, rising 87% in 2017, 4% in 2018, 36% in 2019 and 157% in 2020.

Yet, at the end of 2016, the fund had only $12 million in assets—so its titanic 87% gain in 2017 was earned by a tiny number of investors. By the end of 2018 ARK Innovation had only $1.1 billion in assets; a year later it still had just $1.9 billion.

Only in 2020 did investors begin buying big-time. The fund’s assets tripled to $6 billion between March and July 2020. From September 2020 through March 2021, estimates Morningstar, investors deluged ARK Innovation with $13 billion in new money.

Right on cue, performance peaked. ARK Innovation ended up losing 23% in 2021—even as the Nasdaq-100 index gained more than 27%.

Not many investors captured the fund’s biggest gains. An immense crowd of newcomers suffered its worst losses.

As a result, estimates Simon Lack of SL Advisors, an asset manager in Westfield, N.J., ARK Innovation’s investors as a whole have lost money since it launched in 2014—even though the fund gained an average of more than 31% annualized over the past five years.

In what Mr. Lack calls “an unfortunate downside of human behavior,” no matter how desperately you chase past performance, you will never catch it. You can only buy future performance—which is likely to be hindered by a tidal wave of new money.

ETFs are powerless to deter this tragic cycle. Maybe mutual funds don’t belong on the ash-heap of financial history, after all.

Write to Jason Zweig at [email protected]

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Source: WSJ

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