Interview with Portfolio Managers of The Active Bear ETF: The First Active Short ETF

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The Active Bear ETF (NYSE: HDGE) is the first ETF to take a managed approach to identifying securities to short. The HDGE Portfolio Management Team seeks to identify securities with low earnings quality or aggressive accounting; these factors often intended to mask operational deterioration and bolster reported earnings in the short term. The two portfolio managers are; John Del Vecchio, CFA and Brad H. Lamensdorf.


Can you tell us about your background?

I’ve been focused on short selling for the better part of a dozen years now. I’ve always liked detective work and catching people with their hand in the cookie jar. I went to work for Dr. Howard Schilit, a well known forensic accountant and cut my teeth there on financial statement analysis. I’ve also worked for David Tice, manager of The Prudent Bear Fund, and a well known short seller. I’ve managed two hedge funds and been focused on the short sale positions. I look for companies that are using accounting in an aggressive fashion to mask a deterioration in their business. I pay a special emphasis on the quality of a company’s revenues as it drives the other financial statements and relates directly to end demand for their products and services.

My partner Brad has been trading since he was 13 years old. He’s run a couple of hedge funds, and most notably worked for the Bass family in Ft. Worth, TX where he created baskets of short positions to hedge their exposure. He is more technically focused.

Most short sellers are purely fundamental, and they get creamed by momentum. The combination of forensic accounting and a technical overlay has worked well for us.

What made you decide to create a short ETF?

We feel there are a lack of proper hedging or insurance products in the market. Most ETFs are index based. So, you end up shorting all of the best stocks along with the worst. Also, indexes like the S&P 500 are market cap weighted. The top 100 stocks represent 2/3 of the index weight. Many of them have nice dividend yields. Why short high quality, large cap, value? It makes no sense to me.

Even the Russell 2000 makes no sense. You have to pay the dividend yield and the prime broker jacks up the rate to borrow the shares in a bear market. The market goes down 20% and you’re only up 16% which provides no buffer to your portfolio.

The mutual funds in the space are either always full tilt bearish or have a huge weighting to index futures. Neither helps you out much over a full market cycle.

We pick individual stocks which means we can manage our beta, sector exposure, short dividend yield, short rebates, market cap spectrum, etc. We have a process that we follow consistently. And, while we make mistakes, consistent process leads to consistent results.

So, our ETF not only provides an insurance policy for your portfolio, but also fits into an asset allocation plan.

How were you able to garner over $100m aum in such a short period?

We ran this portfolio has a hedge fund for three years first which I think helped given our record. In addition, we help solve a problem that advisors have. They can’t short stocks directly, and most of the options are index based.

In addition, we have no leverage, no derivatives, and total transparency. Plus, we have intra-day liquidity. We provide a packaged solution to their problem and they buy it all in one ticker HDGE.

Can you clarify for readers (me included), the regulations regarding active ETFs, and short ETFs in particular?

Who regulates active and short ETFs; FINRA, SEC etc.?

Both. AdvisorShares has an exemption with the SEC to offer active ETFs. FINRA regulates the communications with investors.

What are your views’ on inverse ETFs? A passive approach to shorting means that you effectively short every stock in the index. It may not be in your best interest to be short an Apple or a beaten down company that actually be a great long. You may not want to be short good, solid dividend paying companies. Further, many indexes are market cap weighted which prevents investors from fully capitalizing when smaller companies disappoint. While we can understand why some investors would use an inverse ETF as a market timing tool, we prefer stock selection on the short and think such an approach can be a long term portfolio component.  Our research shows that shorting stocks with certain characteristics can deliver absolute returns, not just relative returns.

What advantage did you see for yourself creating a short ETF over having a hedge funds and charging 2/20?

Anyone can buy this fund. It’s exchange traded just like IBM. The mystique of hedge funds is overblown. Both Brad and I have experience managing hedge funds with solid track records. The big secret is that there is no secret.

I prefer this format because it’s open to anyone to buy which creates multiple opportunities for us to build it as a business.

What advantages are there for investors by buying short ETFs over investing in hedge funds?

Since every hedge fund has its own attributes, we’d just say that a short ETF can make since for investors who want to cut overall volatility and have a shot at profiting from a basket of companies that are flawed in some manner.

We also have complete transparency, lower costs, and if you want to get out, just sell the ETF.

Are you personally 100% short or do you also hold longs?

My long positions are in gold and gold related equities. I’ve been bullish on gold since 2002 and Brad has been as well. I think we’re in a secular bull market for metals that will continue for some time. There will be some dramatic pullbacks, but that happens in all long-term bull markets.

What is your investing style; top down, bottom up; value, growth, momentum etc?

I don’t buy stocks. I look for companies with overstated revenues, understated expenses, or questionable cash flows. Then look at how the stock is trading and if it’s not a huge momentum stock will make a fair sized bet against the stock.

What is the process for identifying shorts?

I’ve developed my own earnings quality model that helps narrow the universe. Then it becomes a question of what levers management may pull on the income statement to overstate its revenues or profits. The higher up on the income statement the problem is, the bigger concern I have. So, for example, it management is manipulating the top-line, that would be the greatest concern.

The earnings a company generates are relatively meaningless because there are a lot of line items between the top and bottom line that management can use to manipulate those results.

You seem to have a lot of short positions in consumer discretionary sector and very little in financials. Can you elaborate as to why?

Consumer and technology have historically been easier for me to figure out in terms of their earnings quality. Consumer companies are subject to changing tastes and the broader economy to a large degree. So, when you see management stretching to make the numbers, it gives me more conviction that our thesis will be realized sooner rather than later.

From time to time we have been heavy in financials. We had a big short position on BAC recently, and covered it at a nice profit. In 2007-08 it was the largest sector in our portfolio. So, it just depends on the period of time and the opportunities we find across all sectors.

OpenTable and CRM are two shorts, which a lot of hedge funds are shorting? They are your top two shorts Why are you bearish as well?

OPEN was primarily due to a change in revenue recognition policy. It led me to believe that the company was front loading revenue and at risk of a slow down. That thesis has largely been realized now, but I do think it will trade lower.  It will be a challenge to accelerate the business.

On a GAAP basis, CRM doesn’t look attractive. A couple of quarters ago, even the cash flow was surprisingly weak (one of the benefits of software as a service is more stable cash flows). They’ll never achieve the operating leverage of more mature software vendors. Compensation expense is a big deal and embedded into their culture. I’m not sure how they can yank the rug out from under their salespeople and change the culture to drive higher operating leverage.

You are short GMCR. Do you have anything to add to David Einhorn’s presentation?

We were short GMCR prior to Einhorn’s presentation. It was a small position, but we doubled it before his speech because while we agree with his analysis, the stock was finally starting to trade poorly. It’s no longer a momentum stock so that eliminates the momentum buyer. A value investor would never buy it. Increasingly, the growth picture is called into question. And, once the growth begins to slow, growth investors will bail on the stock and it will likely trade much lower.

What do you think would make this ETF attractive to institutional investors; hedge funds in particular?

We already have hedge funds and institutional investors in the fund. I think the reason why they buy it is because it provides a simple solution to a big problem. They need to have some shorts as a hedge. But, most people walk into the office wanting to find the stock that is going to go up 300%. I walk into the office wanting to find the stock that will go down 25%. And, if I can do that three times a year and compound it out, that’s close to a 100% gain.

Investors that need to find shorts are often frustrated by the process. We have a consistent process that makes sense to them and we have demonstrated it over time.

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