A 20% pullback in Tesla shares over the past three weeks, the biggest holding of the exchange-traded fund Ark Innovation set up by star investor Cathie Wood has triggered a rush among investors to sell some of their holdings.

But according to some who watch the fund closely, a far bigger problem could be its 15%-plus stakes in a handful of companies whose shares are relatively illiquid and potentially hard to exit when redemptions surge.

These include names such as therapeutic discovery company Compugen and three-dimensional printing firm Stratasys whose daily share trading is tiny compared to the overall ETF's turnover.

"They won't find liquidity in many of these stocks," said Ben Johnson, director of global ETF research at Morningstar. "If there's going to be liquidity it is going to come at a price, and it's going to be a price that, in all likelihood, would not be favourable to fund shareholders."

For instance, about $100 million worth of shares change hands on average every day in Stratasys, a stark contrast to Ark Innovation ETF's turnover in single-digit billions and Tesla's in tens of billions of dollars.

Investors yanked $465 million from Ark Innovation on Monday, according to Refinitiv data. More such redemptions would prompt Wood's fund to sell liquid holdings to manage the squeeze in the near-term before looking to unwind its illiquid holdings.

That could turn nasty and rekindle memories of British money manager Neil Woodford's flagship fund, which failed in 2019 because of its exposure to hard-to-sell stocks. That left it unable to meet a flood of redemption requests after a phase of disappointing performance and asset revaluations.

"These large stakes are difficult to exit quickly. This movie has played out before, with the leading role played by Neil Woodford," said Neil Campling, head of technology research at Mirabaud Securities.

Ark Invest did not return calls seeking comment.

The portfolio risk level of the Ark Innovation ETF, which returned 157% last year, ranks well above average on 10 of the 11 factors in Morningstar's Global RiskModel.

Ark Invest meanwhile shuffled its portfolio on Tuesday by cutting its already-tiny holdings in Apple, Amazon, Taiwan Semiconductor and Google-owner Alphabet to beef-up its Tesla stake on Wednesday.

The fund, which saw $5.5 billion inflows in 2021, traded nearly flat on Wednesday as Tesla shares stopped falling.

In 2020, its assets grew nine-fold thanks to small-time investors as actively managed ETFs focused on red-hot themes such as major tech disruptors, space technology and pet care took off.

Investors say Ark's ETF allows funds to invest in specialised niche companies that other large ETFs simply don't take stakes in.

SHORT

The pressure on the fund this week has lured in short-sellers, with 100% of Ark Innovation shares available for shorting out on loan as of Monday, data provider FIS Astec Analytics estimated.

Selling pressure can cause the ETF to trade below net asset value (NAV), which leads to "redemptions" as ETF arbitrageurs exchange the fund for the underlying holdings and then sell the underlying holdings, exacerbating the selling pressure on these ETFs.

In a similar episode, during China's 2015 stock market crash, overseas-listed ETFs of Chinese markets traded at significant discounts to their NAVs.

"ETFs can rapidly gain or lose assets based on the sentiments of their retail investors. These changing flows can act as a self-fulfilling prophecy for ARK," Campling added.

Of course, Ark is not the only fund to bet heavily on a very small number of companies. It is among the biggest, however, and many others have adopted a more cautious approach.

Global X, which has $25 billion in managed assets, uses a concept of "modified market capitalisation" in its thematic ETFs where no company has more than 8% weight in the portfolio, CEO Luis Berruga says.

"We limit the potential situation in which a company can become a very large part of their portfolio and address some of the potential concentration risks in our portfolios," Berruga told Reuters.

Graphic: ARK, Tesla shares in the last two years -

(Reporting by Thyagaraju Adinarayan and Saikat Chatterjee; Editing by Sujata Rao and Hugh Lawson)

By Thyagaraju Adinarayan and Saikat Chatterjee