Earlier this month I wrote an article about a relatively new actively managed ETF called the Active Bear ETF (HDGE). This fund was launched in early 2011 with a goal of using both fundamental and technical analysis to capitalize on short selling opportunities.
Since writing that article, I had a chance to research this fund in more detail, talk to its co-portfolio managers about how the fund works, and follow some of its holdings.
Many investors resort to inverse and leveraged inverse index ETFs, such as the Short S&P 500 (SH) or UltraShort S&P 500 (SDS) ETFs, to "short the market," whether as an outright bet or to hedge long stock positions.
But these funds are synthetic, generating tracking and compounding distortions over time, which I've discussed here. And you're required to short all the stocks in the index. Given its cap-weighted structure, shorting the entire S&P 500 means shorting a lot of Apple (AAPL), Exxon Mobile (XOM), Microsoft (MSFT), IBM (IBM), and Chevron (CVX), which all told account for about 13% of the index.
So what's a bearish investor to do?
One approach might be to take a look at the Active Bear ETF. This is a portfolio of actual short positions so there's no daily return compounding error. And because it's an ETF, you can follow the fund's exposure every market day.
How much does it cost to HDGE?
I feel a bit bad that in my previous article on HDGE I quoted the published expense ratio of 3.29% when actually, the fund's expenses currently max out at 1.85% -- of which 1.50% is a management fee.
I realize that still might seem exceedingly high to some ETF investors. But remember, this is an actively managed fund. Short sellers know that there's a different cost structure to shorting stocks, so it's reasonable that an ETF with existing short positions would have a different expenses than those synthetic daily inverse funds such as SH and SDS.
For example, consider what happens when shorting any stock with a dividend. You pay the dividend if you're short that stock on the ex-date. But HDGE can't debit your account if it happens to be short a dividend stock on the ex-date. If the fund pays a dividend, that's going to be accounted for as an expense of the ETF. The same for any hard-to-borrow fees the fund might pay from time to time.
Think about this. SH has a published expense ratio of 0.90%. Yet the S&P 500 has a dividend yield of about 2%. Do you think you're getting away with not having to pay that 2% if you buy shares of SH or short shares of SPY? Of course not. It's going to come out of the net asset value one way or the other.
I contend that funds like HDGE can a be a cleaner way to maintain a short position in selected stocks, provided you agree with the ETF's philosophy and the way the portfolio managers run the fund. Looking at performance so far, it appears that Active Bear certainly earns its keep when you consider both returns and expenses.
Less drag on your short position
Here's an analysis of how HDGE would have performed against the Short S&P 500 fund over several time frames.
July 1 2011 to September 1 2011
During this period, the S&P 500 went from 1339.67 to 1204.42 - a loss of about 10%.
A long S&P 500 ETF (SPY) position would have lost you 9.7%. A long SH position would have made you 8.3%, but a long HDGE position would have made you 18.4%.
September 1, 2011 to April 2, 2012
From late last year into this spring, the market rallied strong with the S&P 500 index up 17.8%.
Given the impact of dividends, the total return for the SPY ETF was 19.2%. Your long SH position would have lost you 18.7%, which was certainly less than the 22.4% you would have lost on HDGE.
April 2, 2012 to July 2, 2012
Beginning this spring, the bull market stalled, with the S&P 500 index down about 3.8%
SPY would have lost you 3.26%, but SH would have only gained 2.5%. HDGE, on the other hand, returned more like 13.5%.
The full year
It's true that during the September to April period, HDGE underperformed SH, but now let's look at the entire time period - July 1, 2011 to July 2, 2012.
During a year when the S&P 500 index was up barely 2%, SPY returned 4.1% - about the same as HDGE. The SH ETF, on the other hand, lost 9.8%, partially from the impact of dividends and partially from the drag of compounding errors in daily tracking.
So if you're thinking of shorting stocks, consider these charts when evaluating whether an active short fund or synthetic ETF is going to deliver the results you expect.
Matching fundamentals and technicals
So how does the Active Bear ETF work?
Co-portfolio managers John Del Vecchio and Brad Lamensdorf work as a team, with John mostly handling the fundamental analysis and Brad applying his expertise to the technical analysis.
John has a deep background in forensic accounting and summed up his approach on Bloomberg's "Taking Stock With Pimm Fox" back in October:
We identify companies where we think that the earnings that are being reported to Wall Street are not true and sustainable and where management is using financial statements in an aggressive way to mask a deterioration in their business.
When our view of what the true and sustainable earnings diverge enough from what Wall Street thinks it's going to be, that's provides us an opportunity to short the stock with the expectation that there will be a reduction in guidance, maybe a revenue miss, or an SEC investigation in an extreme case.
When I talked to John, he told me he's one of those analysts who actually likes to dig through all those arcane footnotes you see in those quarterly and annual reports. And he's not doing it to uncover hidden value, but to uncover a hidden lack of value.
As John pointed out, "What's surprising is that all this information is publicly available. They say that makes the market 'efficient,' but you'd be surprised how many people don't seem to understand what some companies are really telling you in their reports."
However, as many short sellers discover, just because a company seems doomed doesn't mean a stock can't continue to soar higher and higher for weeks or months. That's the short seller's peril. How many people were right on a stock like Green Mountain Coffee (GMCR) or Netflix (NFLX) but ended up forced to cover their short positions way too early at significant losses?
That's where technical analysis comes in. Based on his many years of experience in managing short portfolios, co-portfolio manager Brad Lamensdorf keeps tabs on what's going on technically, both at the macro level and for each portfolio holding.
He explained to me that he evaluates the overall market, liquidity and breadth, and how specific targeted stocks are trading, such as watching for distribution days.
Like most professional short sellers, his goal is to pick levels where it makes technical sense to short and add to shorts, and where it makes sense to take profits and lighten up.
The fund managers over at SH? They don't do this. Why? There aren't any fund managers over at SH. That's the whole point.
Active ETF Transparency: Reviewing holdings on a daily basis
Unlike actively managed mutual funds, you can see how an active ETF such as HDGE is managing its portfolio on a daily basis. And I have to admit that it's kind of fun to watch an active ETF change from day to day.
For example, I happened to notice that between July 15 and July 18, a short position in Deutsche Bank (DB) was reduced from 3.61% of the HDGE's short holdings to 2.8%. At the exact same time, a short position in Goodyear Tire (GT) was increased from 2.69% to 3.13%.
Here's a look at the fund's top positions as of July 22.
So if you're a bear, or think you might become one even for a short time, consider an active ETF like HDGE instead of reaching for one of those passive inverse funds like SH.
Or at the very least, you can review John and Brad's portfolio every day for ideas. They're certainly not perfect, but if you're long a stock or thinking of buying one, you might want to know whether John and Brad are shorting it.