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In times of market stress and volatility, many investors decide to hedge their equity exposure in an attempt to minimize their losses. There are many ways investors can attempt to minimize their losses, from currencies, to gold, to outright shorting of various markets. We would like to highlight a different hedge, one that we believe offers a variety of benefits for investors looking to hedge their equity exposure.

The AdvisorShares Active Bear ETF (NYSEARCA:HDGE) is a unique creation. The fund is an actively managed short ETF that shorts individual companies, not entire indices, based on several criteria, including those with poor earnings quality or "aggressive" accounting. Since its inception in January 2011, the ETF has accumulated nearly $300 million in assets under management. We delve into why we believe this ETF is a good equity hedge below.

A Different Kind of Short

When investors wish to hedge their equity exposure with short ETFs, many choose to simply buy an inverse ETF, such as the ProShares Short S&P 500 (NYSEARCA:SH). That ETF, with an expense ratio of just 90 basis points, shorts the entire S&P 500. In theory, its performance will be a mirror image of the S&P 500 (NYSEARCA:SPY). However, markets rarely behave according to theory, and this ETF is no different. The ProShares Short S&P 500 may be an unleveraged fund, but it still resets daily. The associated effects of compounding mean that over time, this ETF's performance breaks down, and it becomes unable to mirror the S&P 500. The fund's performance over the past year is proof.

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With the S&P 500 down just about 2% in the past year, common wisdom suggests that the ProShares ETF would be up somewhere around 2%. Instead, it is down over 6%, as the effects of compounding render its shorting qualities useless. ProShares' ETF is meant for daily shorting, not medium-term or long-term exposure. The fact that it resets daily is responsible for this.

The AdvisorShares Active Bear ETF, however, does not suffer from this particular flaw. Not only is it actively managed, it does not reset at all. Its short exposure is constant, and that is what drives outperformance in the medium-term.

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The AdvisorShares ETF is up nearly 10% over the past year, compared to the S&P 500's drop of around 2%. How can a short ETF outperform by such a large gap? Shouldn't it be a mirror image of the S&P 500?

The reason for this outperformance is the fact that this ETF is actively managed. AdvisorShares does not simply short every stock in the S&P 500. There are just 37 stocks in this ETF, and the ones that are included are those that perform the worst during market selloffs. Currently, the fund's top 2 holdings are Deutsche Bank (NYSE:DB) and Citigroup (NYSE:C), with 11.82% of assets dedicated to shorting those 2 companies. Other top holdings include Goodyear (NASDAQ:GT) and Rockwell Collins (NYSE:COL), and these are exactly the kind of companies that lead market selloffs.

Furthermore, this ETF's focus on companies with weak fundamentals allows it to score outsized gains when the market turns against them. 2 other top holdings of this ETF are Acme Packet (NASDAQ:APKT) and Best Buy (NYSE:BBY), which have both dropped over 22% year-to-date, due to worries about their fundamentals, not just broad market weakness. Companies with fundamental issues, such as Best Buy are much more likely to underperform the markets in weak environments, which gives the AdvisorShares ETF an added leg up on passive short ETFs.

The market's recent slide has once again allowed this fund to prove itself, and demonstrate its potential to investors. Since its 2012 high, the S&P 500 is down around 10%, and the ProShares Short S&P 500 ETF is up around 10% as well, showing that in the short-term, it can correlate well to the market. The Active Bear ETF, however, is up over 22%, due to the fact that its portfolio is composed of companies most likely to fall the hardest in a market slide.

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The AdvisorShares Active Bear ETF offers a unique twist on shorting the markets and hedging equity exposure. However, given the fact that there is no such thing as a perfect investment, what are the downsides of this ETF?

Expenses: An Achilles' Heel?

The diversification and accessibility ETFs provide do not come free. Every ETF has an expense ratio, although most are relatively minor. The ProShares Short S&P 500 ETF has an expense ratio of just 90 basis points, which is low given the fact that it is a short ETF. The AdvisorShares Active Bear ETF, however, likely has the largest expense ratio of any ETF, coming in at 3.29%. Though this is capped at 1.85% until October, it is still a large expense ratio for any product, let alone an ETF. Therefore, it is important to examine what this 3.29% consists of.

The management fee for this ETF is 1.5%, which is not unreasonable given the fact that it is actively managed and is in a niche of the investment world. The remainder of the fund's expenses come mostly from the cost of maintaining constant short exposure to a basket of a few dozen stock. The ETF's short interest expense comes in at 1.44%, with other minor fees making up the rest.

So is the expense ratio worth it? We think so, and that is why we hold shares of the Active Bear ETF. The fund has proven itself since inception, down just 0.63% as of this writing, compared to a loss of over 9% for the ProShares Short S&P 500.

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This ETF does not suffer from the compounding issues of the ProShares ETF, and we feel that for investors looking to hedge their equity exposure, the Active Bear ETF is well worth the cost.

Best Uses

We feel that it is too early to tell whether or not this ETF is a long-term holding or not, given that it has been on the markets for under 2 years. Therefore, we will explain how we use this ETF in our portfolio, for we believe it is the most prudent way to do so.

All investors must be aware of the fact that the market is rarely, if ever rational. There are periods when macroeconomics take a backseat to corporate fundamentals, and there are periods when the opposite is true. The current market environment is one where corporate fundamentals do not seem to matter. Hysteria over Europe and a slowing American economy mask investors' ability to discern which companies are thriving from those that are not. Our portfolio has certainly not been immune to this. The majority of companies we hold, such as Apple (NASDAQ:AAPL), CME (NASDAQ:CME), EMC (NYSE:EMC), or Costco (NASDAQ:COST), are all companies with secular tailwinds and great balance sheets. Yet the market does not appreciate that fact. Therefore, we decided to turn to the AdvisorShares Active Bear ETF to minimize our potential downside risk.

Our intent with this ETF is not to hold it indefinitely. Rather, our goal is to use it to hedge downside risk, and should markets continue to slide, sell it and use the profits from that sale to make additional investments in the companies that we hold, or new companies that we deem to be fundamentally sound. Whether or not this ETF will be a long-term hold remains to be seen.

Conclusions

Investors who wish to hedge their equity exposure should consider the AdvisorShares Active Bear ETF. The fund's unique way of providing short exposure has worked well in the past, and should continue to work well in the future. When paired with long positions, this ETF offers investors a good way to profit from market downturns and increase allocations to existing companies, or initiate new investments.

Source: Buy The AdvisorShares Active Bear ETF: A Different Kind Of Market Hedge