John Del Vecchio's new Active Bear Exchange Traded Fund, (HDGE), is the opposite of what you'd expect: it's relatively expensive in a category dominated by low-cost funds, it's transparent in a field (shorting) that's all about secrecy, and though it was only launched a month ago, it's already collected $37.7 million in assets under management.
ETFs have grown into a $1 trillion asset class largely because they're a cheaper version of index mutual funds. But HDGE is part of a new breed of ETFs, funds that are not just passive plays on an index, but are instead actively managed, requiring expertise and research, and carrying higher fees.
Like their Index-shadowing brethren, actively-managed ETFs trade throughout the day like any stock does, while mutual funds can only be bought and sold at the end of the day. ETFs also must list their holdings at the close of the day, unlike funds which disclose that information quarterly. That's an especially interesting wrinkle for HDGE, given the secrecy in which shorting stocks is generally conducted. As of the end-of-day March 8, here are the fund's top 10 holdings:
Ticker Name Weight
|AGO||ASSURED GUARANTY LTD||-3.62%|
|BYI||BALLY TECHNOLOGIES INC||-3.51%|
|DRIV||DIGITAL RIVER INC||-3.22%|
|WMS||WMS INDUSTRIES INC||-3.09%|
|MAR||MARRIOTT INTERNATIONAL INC/DE||-2.94%|
Short sellers borrow stock, then sell the borrowed stock. They hope for it to go down in price, so that when they have to replace the borrowed stock, they can do that with cheaper shares and pocket the difference as profit. One of the reasons short sellers are generally so quiet is fear of something called a short squeeze, where other investors buy up a lightly traded company which many sellers are shorting. This drives up the price of the stock, which leaves shorts, who have to buy at those high prices to cover the shares they borrowed, deep in the red.
Del Vecchio says he avoids this issue by largely trading highly liquid stocks, many with a low level of short activity.
He also does not use leverage in his fund, or derivatives, techniques which have gotten other Exchange Traded Funds into trouble.
Short Track Record
Many retail investors avoid investing in funds with such a short track record, so Del Vecchio is relying on his own history in the business to help get the fund off the ground.
Del Vecchio started his career in financial sleuthing working for Howard Schilit's well-known forensic accounting firm the Center for Financial Research and Analysis, now part of Morgan Stanley. Later he worked for David Tice, manager of the Prudent Bear mutual fund, who made his reputation decrying Tyco years before its CEO and CFO went to jail. Del Vecchio left there in 2007 to start his own hedge fund, which did especially well in the down markets of 2008. Uncomfortable with the secrecy and exclusivity of the hedge fund world, he says, he started the steps to launching this ETF a year ago.
What's a Short?
Like his mentors, Del Vecchio specializes in taking a highly skeptical look at company's financial statements. His motto is: "All companies are guilty until proven innocent." And his record running hedge fund money shows strong returns over the long-term.
How deeply he gets into a short position depends on his level of conviction. He's most confident when he thinks a company's top line, its revenue, is suspect. If the revenues are legitimate, even if the earnings number is being juiced, the company is likely to be ok. This is a lesson Del Vecchio learned in the 1990s watching shorts get fleeced on AOL. The internet provider's earnings were indeed incorrect, and they eventually paid a fine to the Securities and Exchange Commission, but the company's revenue numbers were real and growing and that saved their stock. Similarly, Netflix (NFLX) is a company with many detractors for many years, but Del Vecchios never found an issue with their revenue, and he's never shorted the stock.
Juniper Networks (JNPR) is an example, Del Vecchio says, of a company where he has questions about the revenue. A change in their revenue recognition policy last year he believes has made the company's growth look better than it is, and that this year when it starts to face comparisons to those sweet 2010 numbers it will end up disappointing the Street. His payoff typically comes, he says, when a company missing earnings, brings down guidance or announces an SEC inquiry, all of which are likely to push the stock down.
After revenue he starts to worry about gross profit margin. Green Mountain Coffee Roasters (GMCR), is a company he's short because he thinks their cash flow is small relative to where it should be based on their growth rate, and because they recently paid a lot for an acquisition, possibly reaching for growth.
But whatever the cause of his skepticism, he has to have the discipline to recognize if he's wrong:
If the numbers get better you just get out. I don’t have any particular feelings about the companies. I don't hate them or their management. But every stock at some point in time under-performs or sells off, every business has a slowdown at some point. The question becomes when that slow down comes is management open and honest about it, or do they try to paste that over and pull the wool over everyone's eyes.
In a recent piece on Seeking Alpha explaining why he's invested in HDGE, Mycroft Psaras says he ran Green Mountain and Juniper through his own cash flow-focused screens and found both overvalued, reaffirming his faith in Del Vecchio's assessment.
Can HDGE work for Average Investors?
ETFs are twenty years old as a concept, but have really started to gain steam over the last few years. There are over 1,000 available now and more than $1 trillion is invested in them as a group. Once dominated by large institutional investors, ETFs are increasingly held by mom-and-pop investors. According reports, at Charles Schwab & Co., for example, retail investor ETF assets have grown 61% over the past year and now are 37% of the $110 billion in ETF assets held at Schwab. Credit Suisse research concludes many of the dollars flowing into ETFs are being taken out of traditional mutual funds.
That's a trend that worries some, including Vanguard founder John Bogle, who has been an especially vocal critic of Exchange Traded Funds, arguing they encourage excessive trading by investors and that their more exotic forms are quite dangerous. Last year Bogle cited Vanguard research that found ETFs didn't always perform. Their finding: the returns on 175 ETFs studied fell about six percent short per year of the actual index they tracked.
Morningstar research has found that the best single indicator of any fund's future performance is low fees. That's problematic for HDGE, which charges an 1.85 annual fee. 1.5% goes to the fund managers, the rest to expenses. That's more expensive than the figures Morningstar sites for the average US stock ETF (0.49%) the average actively managed ETF (0.82%) and even the average actively managed U.S. stock mutual fund (1.39%.)
Del Vecchio says his fees compare favorably to mutual funds and certainly to the hedge fund world he comes out of. Another option, directly shorting the market, incurs trading fees and dividend costs. Because he's picking 20 to 50 individual stocks, he argues, he also stands a chance of outperforming that kind of static hedge.
He sees HDGE as a smaller portion of most investor's portfolio, a balast to right the ship if a bear market does settle in for a while. "Every investor needs some sort of insurance policy for their investments," he says. "There were no good viable products to fill that void. You have insurance for your house. Why not for your investments?"
It may be in his nature, but Del Vecchio thinks now is a good time to be shorting the market, and not just because of recent uncertainty in the Middle East. Other things that have him feeling cautious:
- Investor ebullience: There are three bullish advisor for every bearish one. Cash held in mutual funds is at multi-year lows. Investor surveys show the average investor is also quite bullish.
- High prices: 90% of stocks are above their 200-day moving averages, 80% above their 50-day moving averages.
- Unemployment: real unemployment is close to 16 or 17%. Food and gas prices are rising. With an economy based on consumption, there's no lasting strong recovery until more people are back to work.
- Doubtful that cash on the sidelines will come back: Investors burned by the 2008 mess are not coming back, and the swell of babyboomers are moving into retirement when they will be net redeemers of stock.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.