Courtesy of John Nyaradi.
Today’s equities markets are nothing, if not volatile, and Active Bear ETF (HDGE) is a relatively new exchange traded fund that offers a unique opportunity to “short” stocks and hedge a portfolio within the structure of an exchange traded fund.
Here’s an exclusive interview with John Del Vecchio, sub-advisor to the Active Bear ETF:
John Nyaradi: Hi, I’m John Nyaradi, publisher of Wall Street Sector Selector, a financial media site specializing in exchange traded funds and global markets. Today, I’m really pleased to welcome our special guest, John Del Vecchio. John, welcome to Wall Street Sector Selector.
John Del Vecchio: Thank you very much for having me today, John.
John Nyaradi: John Del Vecchio is a principal of Ranger Alternative Management and is sub advisor to the Active Bear Exchange Traded Fund. He has been a consultant to institutional investment managers, a portfolio manager of a short only fund and early on in his career, was an analyst for The Motley Fool and he holds the Chartered Financial Analyst designation.
Today, we’re going to talk about his ETF which is called the Active Bear ETF. The symbol is (NYSEARCA:HDGE) and Active Bear is in a new class of ETFs, those that are actively managed.
So as I understand, John, the Active Bear strategy manages short selling securities, which is kind of unique. Just tell us a little bit about what you do and how that works inside the ETF.
John Del Vecchio: Sure. I started as a forensic accountant about 12 years ago, finding companies that were aggressive in their accounting while masking deterioration in their business. In some cases, they were fraudulent and in other cases, they were just companies experiencing a bump in the road and management was utilizing accounting in an aggressive fashion to paste over a slowdown. And then I worked for the Prudent Bear Fund where I utilized essentially the same strategy, and after that we managed the Active Bear strategy as a hedge fund for three to three and a half years before we converted it into an active ETF.
And our process is very simple. We look for companies where earnings that they’re reporting to Wall Street and to the public are not truly sustainable, where management is pulling leverage on the income statement to understate expenses, overstate revenue, overstate the bottom line earnings, and that of course flows to the balance sheet and the cash flow statement. So we’re an active ETF because we’re active stock pickers. We’re not based on any particular index so we’re not dependent on the market going down, we’re dependent on finding companies that under perform in order for us to succeed as short sellers.
John Nyaradi: So inside the Active Bear ETF, how many stocks would you typically hold at a time?
John Del Vecchio: Typically, 20 to 50 but our comfort zone is somewhere around three dozen positions so we’re somewhere and the mid 30s most of the time. That gives us not too much concentration on any particular stock, but the reality is that no one ever knows when a particular company may blow up and suffer a big decline in share price. So we’re diversified across consumer, technology, industrial, health care, and
financials. We really try to concentrate on whatever the underlying accounting issues are.
John Nyaradi: You talk about a core and a tactical approach to your work. Can you just discuss that in some detail?
John Del Vecchio: We look at companies based on fundamental problems with respect to their accounting, but when we actually short them and manage our exposure once the trade is on, it’s also a tactical consideration. So we like to see companies that are already undergoing distribution or selling pressure in the stock price. A very good example would be Open Table, which was our largest short position going into their earnings release. In October, the market was exceptionally strong, one of the strongest months in decades.
John Nyaradi: Right.
John Del Vecchio: And Open Table just wouldn’t go up. There were days where the Dow was up 300 points and Open Table was down 4%, 5%, 6% and that’s telling us that there is significant selling pressure. Now we already had a fundamental case for Open Table and we thought it was a compelling short idea. But when we’re seeing a strong take that a stock just can’t participate in that rally then we get very aggressive in terms of adding to our position because we know that there’s selling pressure going on there and it’s likely a big institution. Who that is, I don’t know. But for instance, an institutional investor such as Fidelity, if they own a stock, it takes them a very long period of time to exit that position. They don’t do it all in one day and that tends to weigh on a stock over time. By using shorts, that allows us to see where there’s accumulation in the marketplace, where there’s distribution and we want to allocate our capital to companies that are already starting to act poorly in the current market environment.
John Nyaradi: There has been a lot of publicity and talk about inverse ETFs and they’ve been used in all kinds of ways both good and bad. Can you compare and contrast the Active Bear ETF to an inverse ETF?
John Del Vecchio: Sure. We don’t use any leverage, first of all, compared to the double and triple leverage inverse funds that have been a total disaster from an investor standpoint. The longer you hold those securities, the greater the tracking error versus the underlying index. So for instance, if you bought one in January and you sold it in June and the market was down 50%, you don’t make 100% in your double leverage ETF. In fact, you may even lose money because it’s reset every day.
John Nyaradi: Right.
John Del Vecchio: So the biggest difference is we have no leverage. The second difference is we don’t reset our portfolio everyday so even if you own an unleveraged ETF like SH, you know, recently the market was down in the single digits. We were up mid double digits and yet SH was flat so it didn’t even do what it was supposed to do, which is track the inverse of the S&P 500. And part of that is because volatility tends to be higher in bear markets or down phases and the resetting of the portfolio daily by these inverse funds magnified the impact of that volatility. We actually use volatility in our favor because we’re not leveraged and we’re not resetting our portfolio.
And then I think the biggest difference is this. The S&P 500 obviously has 500 stocks. The top 100 stocks are approximately 2/3 of the index weighting because it’s a market cap weighted index. So it’s really the S&P 100 plus 400 stocks that are only a third of that weighting. So when you look at the components of the S&P 500, you have to ask yourself do you really want to be short Microsoft and Apple and Bristol-Myers and Merck. Companies that have either pretty decent valuations or significant dividend yields whereas we’re shorting companies that have specific issues. It’s not related to any particular index. We view that as a much better way to short stocks because why would we want to be short Bristol-Myers at a 4.5% dividend yield when there’s nothing wrong with that company. Yet when you short the S&P 500, you know, 2% of the capital is getting allocated to that security and that to me is a very inefficient way to short the market.
John Nyaradi: That’s a great point. Can buy the Active Bear ETF inside a qualified account like an IRA or 401k, in effect going short within a qualified account in which you’re normally not allowed to do that?
John Del Vecchio: That’s correct. When you buy our fund, you’re going long our fund but short the underlying stocks. You can buy and sell it all day long. It has a considerable amount of intra-day liquidity for an active ETF, and probably the best thing about our portfolio versus other
products that are out there in the marketplace is it’s fully disclosed. You can go on to the advisor shares website and register for free and see what our holdings are and get a sense of the type of securities that we’re short.
John Nyaradi: Can you kind of give us a little profile of Active Bear, average daily volume and assets and so on?
John Del Vecchio: We’re approximately $150M in assets under management. We launched in January of this year. We trade roughly 225,000 to 250,000 shares a day which is plenty of liquidity because the liquidity of an ETF has to do with the underlying positions, not the ETF
itself.
John Nyaradi: That sounds great. Now hedging, you know, a lot of our readers today are retail investors and hedging is something the pros do, something a retail investor doesn’t usually know a lot about. Could you talk about hedging and why we should do that?
John Del Vecchio: Well I’m sure most, if not all of your readers and subscribers have insurance for their home and insurance for their car and yet your house doesn’t burn down every day and you don’t get into a car accident. But it’s assured that the stock market is going to take big tumbles at some point in time to the magnitude of 30%, 40%, 50% and it seems like the hundred-year storm happens every four years so you never know when it’s coming and so a portion of your portfolio should be hedged simply as an insurance policy. What if you were set to retire in 2009 and 2008 came along and wiped that 60% of your capital? That’s not a good position to be in.
So from that perspective, it makes sense to have a hedged position on at all times. In addition to that, you might have a tactical position so when you, for instance, have a sell signal on the market then maybe it makes sense that you top up that position to take more exposure on the short side to capture a down move in the market.
And then a third way to play our funds specifically is that every company in our portfolio we think will either miss earnings, have missed revenues, have a reduction in guidance or in an extreme case, an SEC investigation. So during earnings season, if we do a good job of picking those individual stocks, even if the market is going up, if XYZ company misses earnings, chances are it’s going to get hit pretty hard. And that gives you a chance to generate extra gains without holding our funds for an extended period of time just over, you know, a four or five-week time period.
John Nyaradi: I always like to end these conversations with sort of an open ended question, so as you look at the world today and the market and the economy, is there anything particularly on your mind that retail investors should be watching out for and thinking about here as we move into the end of 2011 and then look ahead to 2012?
John Del Vecchio: Yeah, a couple of things. One is that there’s going to be a significant amount of volatility for a long period of time and I know that makes a lot of people uncomfortable. We try to use volatility in our favor and make it work for us. But I think with the number of hedge funds that are out there in the marketplace, high frequency trading and even these leveraged ETFs that are resetting every day, the volatility
is just going to continue for the unforeseeable future. And it’s a different environment. So not that it keeps me up at night, but I think that your investors just need to be prepared for significant volatility for an extended period of time.
Secondly, I believe we’re in a secular bear market and that has not changed even off the bottom of 2009. These markets tend to last 12, 15, 20 years. If you look at a chart of Japan, for instance, there are a lot of times where you can see where the market rallied against the trend by 30%, 40%, 50%. And when we are living that in real time, it makes you think that you’re back in a new bull market until something comes along and knocks the market down considerably lower. I just don’t think we’re going to be out of this until there is some new invention or some new reason to invest or the stocks get ridiculously cheap and are yielding 5%, 6%, 7%, 8% in an environment where interest rates are 0% or 2%.
So I think we have a lot longer to go. I don’t know what that new industry is going to be, it could be something in biotechnology, it could be something in green energy. But it needs to be something to get people excited again about owning stocks or valuations need to become more compelling and I think that that’s just a matter of time. It could be three, four, five more years before that occurs and that the market can then start to really accelerate.
John Nyaradi: Well, folks we’ve been talking with John Del Vecchio. He’s sub advisor to the Active Bear Exchange Traded Fund. The symbol of that fund is (NYSEARCA:HDGE) and you can learn more about John and his work and the Active Bear Exchange Traded Fund by clicking on the link at the bottom of this interview.
John, it has been really great chatting with you today. I appreciate your time, I’ve learned a lot and I want to thank you for joining us. I know we’re all looking forward to talking with you again real soon.
John Del Vecchio: Great. Thank you very much.
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