John Del Vecchio is the Portfolio Manager and Principal at Ranger Alternative Management, L.P., the firm that recently partnered with AdvisorShares on the Active Bear ETF (HDGE). He recently sat down with ETF Database to discuss his approach to identifying short sale candidates and potential applications for a short only fund within a portfolio:
ETF Database: Your firm has recently partnered with AdvisorShares on the Active Bear ETF (HDGE). What makes this new ETF different from the other options for short equity exposure on the market already?
John Del Vecchio: HDGE is the only actively-managed short ETF in the marketplace. Until HDGE launched there were only index-based inverse options in the ETF space and a variety of bear funds in the mutual fund space. But there hasn’t ever been an option that was both actively-managed and packaged in the ETF wrapper. We think that our product is unique in that we utilize a specific process to identify companies that are positioned to underperform.
When you short an index fund, you are also shorting the best companies and the undervalued companies in the index as well. We believe that packaging our short-only strategy in an ETF gives a wide range of investors access to a strategy that can generate alpha consistently over a full market cycle. Until now there hasn’t been one, so we are excited to be the first.
ETFdb: Forensic accounting is at the heart of what your team does and your effort to find stocks that are short sale candidates. Explain the methodology that you use in identifying which stocks should be sold short.
JD: I am a forensic accountant by trade, and you’re right: forensic accounting is very much at the heart of our strategy. I started my career at the Center for Financial Research and Analysis (CFRA) and also managed a few hedge funds over the years that focused on short only strategies utilizing forensic accounting. What I mean by “forensic accounting” is that some companies use accounting in an aggressive fashion to mask deterioration of their business. So if demand is falling for a company’s products and management goes out and does something to make revenue look better than it is on a truly sustainable basis, that is what we pay attention to and try to identify. We try to understand what is driving earnings on the income statement, and utilize the cash flow statement and balance sheet as well to determine whether or not the earnings being presented to the marketplace are true and sustainable.
The reason why we use this process is that it is consistent across companies and across time. From generation to generation the company has changed and the management has changed, but the behavior of pulling levers on the income statement and overstating profits doesn’t change. And part of that is because the management team is often highly incentivized to keep their stock prices elevated; they generally have either stock options or outright stock grants that are a large part of their overall net worth.
They also tend to be optimistic about the business. When it appears that business is about to slow down and they have to meet Wall Street expectations, which is a difficult thing to have to go through every quarter, they tend to reach into the cookie jar a little bit and find sources of earnings growth and revenue growth that allow them to mask that slowdown. The problem is if that slowdown is real and is a much bigger problem than a one quarter drop off, then they are a mouse on a treadmill. So we utilize accounting to identify those companies and get a sense of their true earnings. If enough red flags are raised and if a company meets our criteria, then that will make for a shorting condition.
ETFdb: Most investors are probably familiar with the more extreme examples of this aggressive accounting - Enron for example - but less familiar with accounting that might be aggressive without being fraudulent. In other words, companies that might make short sale candidates don’t have to be full-blown frauds that are headed for bankruptcy; there are various points along the spectrum as far as how aggressive companies can be with their accounting. Is that fair to say?
JD: That is exactly right, and it’s a great point. We don’t really look for fraud; that’s not what we are seeking to find when we conduct our analysis. What we are seeking to find are companies who are undergoing a slowdown in their business and are using accounting in an attempt to mask that decline. So it does not necessarily mean that their business is going to go away a year or two down the line, or that they are doing anything illegal. There are a lot of shades of gray.
While they may not actually be doing anything illegal, they are being aggressive. They way we think about it is this: on an income statement you have revenue on the top and earnings on the bottom. And Wall Street and most investors are always focused on EPS, and beating that number. The reality is that if a management team in an extreme case has completely fictitious revenues, then its entire financial model would be bogus.
We try to find companies that are pulling revenues from a future period into the current period. And they do that by extending payment terms to their customers; for instance they get customers to sign a contract today that would otherwise be signed at a later date. And what that does is it creates a revenue gap. The revenue was stolen from the future and pulled into the current period, and now they have to fill that gap down the line in order to keep their revenue trajectory on the path that it was on. The problem is if business wasn’t slowing down in the first place, there is no incentive for management to go out and offer those easier terms to customers.
So it is not so much that this hypothetical company is doing anything fraudulent, it is just doing something aggressive. And what it is telling me is that the revenues that they are reporting in this quarter are not really reflective of the underlying demand for the product. And if they don’t fill that gap a year or two down the line, that is where there is a high degree of risk that they are going to miss earnings.
We think that every company in our portfolio will be impacted by an earnings-driven event, whether it be missing earnings, guiding down future earnings, or even having an SEC investigation based on some sort of accounting policy. But we do not necessarily think that their business is going to go away. And that is different from a lot of short sellers, and I think that actually is an advantage for us. Every company at some point in time stumbles, no question about it. The question is, does management acknowledge that? Saying “we know this is a slowdown, we are doing X, Y and Z trying to fix it.” Or do they pull the wool over investors’ eyes and say “everything is great” and try to paste over that slowdown. In our analysis, we are really going for the latter: management teams who are not being honest with the underlying demand for their business. We won’t really spend too much time focused on companies that are going through trouble, but management is open and honest about the troubles they are going through. There is much less of an opportunity with those types of companies.
ETFdb: As a forensic accountant, have you noticed any change in accounting practices either during or in the wake of the most recent recession? Have you seen companies get more aggressive as a result of the downturn?
JD: I would say that at the lows you got a lot of free passes. When the market was at its bottom in early 2009, there was really no reason to be aggressive because your earnings could have been abysmal and investors and analysts would have given you a free pass given the broader environment. So I think at the lows, you definitely did not see management teams being their most aggressive. But what happened is that the market snapped back very, very hard, and nine months later the S&P was up considerably.
The average stock was up more than 60% in 2009, and there started to be a bifurcation between companies where business really did come back and companies that did not recover. And so we decided to focus on companies that were utilizing accounting to essentially indicate that their business was stronger than it really was. So that bifurcation I think really started to take place in late 2009 or early 2010. We have had companies change revenue recognition policies and companies that are certainly pulling revenue forward and reporting poor cash flows. So we are starting to see a lot of opportunities now, almost two years removed from that low. So that has created an advantage for us especially in the timing of HDGE. If it had been launched at the lows, there might not have been as much opportunity at that point in time.
ETFdb: So it sounds like in certain markets, meaning a bull market/bear market or recession/recovery, there may be more opportunity for a short only strategy?
JD: Well, the difference is that because we are actively managed we have the ability to alter the composition of our portfolio depending on the broader economy. So in a market like we have now - where we have had an almost unabated run, absent a move in the spring of last year to the downside - we believe stocks are incredibly overbought. So in that situation we are going to be very aggressive in the stocks that we short - ones that we sense have tremendous downside.
But even in a bear market, or one that is washed out by a total recession, there are opportunities. It’s just that they are different types of opportunities. I became bullish in December of 2008, and I rotated about 40% of our predecessor fund into stocks that had aggressive accounting, including General Mills (GIS). The way that General Mills has earnings power is by buying back shares and manipulating their tax rate, so in a deeply overbought market like we are in now, General Mills is not going to sell off as hard as other stocks because it is viewed as a safety; they are going to be selling cereal for the next 200 years, long after we are all gone. The dividend is fairly safe, but they are pretty much a 1% grower. At the first snapback rally following a bear market, stocks such as General Mills that are viewed as slight safeties are rotated out of by investors who want to get into the "junky" stocks.
In 2009 there was a massive junk rally; the stocks with the most leveraged balance sheets and the stocks with the highest revenue multiples and no earnings were the ones that went up the most. And they were also the most volatile. So we have the ability in a recession to really take in securities that won’t benefit when the market snaps back, which is why our performance was what it was against average stocks in 2009. There is always the opportunity, it’s just that the opportunities are different depending on the broader economy. And right now given that the market has had a massive run for two years, and we are skeptical about the growth of the economy, we are going to be the most aggressive about the kind of stocks that we short. If we do see a pullback or a crash, we will be able to move our portfolio into something else. What that allows the investor to do is to hold HDGE for a full market cycle; it is not dependent on a bull market to generate alpha.
ETFdb: Why launch this strategy in an ETF? Why does the marriage of the exchange-traded structure and the short investment strategy create value for investors?
JD: For starters, we have total transparency as a function of being an active ETF; we disclose our portfolio everyday. Others in the market place don’t have total transparency. At the end of the day we are cheaper than our competitors, because if you short an index based ETF you are funding the dividend yield and a decent sized negative rebate. In 2008, for example, sometimes it cost over 3% a year to short IWM on an annualized basis. And what we do is that we manage our dividend yield so that we are not paying out a significant dividend yield. So that gives us a huge cost advantage over passive short ETFs on the cost side. And then with mutual funds you have limited flexibility in trading, whereas with an ETF you have high intraday liquidity. That is a huge advantage to an investor who is concerned with short term moves in the market as well.
ETFdb: So how could investors or advisors use HDGE in their client portfolios? The obvious appeal is to those who believe the market is going to do poorly, but are there other potential applications within a portfolio as well?
JD: Some investors may think of HDGE like an insurance policy. You have an insurance policy on your car, on your house, but your house doesn’t burn down every day. So this allows you to allocate HDGE in an overall asset allocation model and to capture the alpha that we generate in up markets, down markets, and sideways markets. And if we can continue to do our job as we have done in the past, we should be able to generate alpha that improves your risk/reward ratio. And certainly if you are bearish on the market you can scale it up. So if you have a 5% static position, maybe get it to 15% if you are bearish, and you bring it back to 5% under more normal market circumstances. But it is always there to provide a buffer to your portfolio. Again the difference is that because we are actively managed, when the market is in deeply oversold territory we start to get bullish - we adjust our portfolio accordingly. And that’s just not occurring with the other products out there that offer short equity exposure.
You can also set up a synthetic long/short fund with this product by pairing it with exposure to a traditional equity ETF such as RSP. Basically you can take the dividend yield from the S&P and you can pay us to manage the short portfolio with an opportunity to end up with some sort of positive carry. It is a market neutral situation in your portfolio that has no lock up, no fee, and you basically put on a long/short large cap domestic spread that outperforms many hedge funds. So there’s an opportunity to mimic a hedge fund strategy with more flexible securities. It is hard to get into a hedge fund, and the lock ups, fees and illiquidity are all potential drawbacks to the returns generated. Here, brokers can use ETFs that are bought and sold throughout the day, simply slapping them into their portfolio to get the same type of exposure.
Disclosure: No positions at time of writing.
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