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April 5th, 2012 by Jeff Reeves

Active Bear ETF: Insurance for your portfolio -By Jeff Reeves, Editor of InvestorPlace.com

Manager John Del Vecchio on why his ETF isn’t tied to an index and why it’s a great hedge

“The stock market is far more likely to blow up…than your house is likely to burn down.”
– Active Bear ETF manager John Del Vecchio

A lot of investors have been feeling bearish lately after the stock market’s red-hot run since Thanksgiving. After all, expensive oil, high unemployment, persistent housing trouble and more provide good reasons to doubt the rally.

If you’re in the bearish camp, or even if you’re just an investor who likes to hedge your bets, it’s worth noting that there are a number of investments that can help you play the downside of stocks.

I’m not talking about buying puts or short-selling on margin. I’m talking about the most mundane of all investments to profit from a fall in the market: an actively managed ETF.

It sounds odd, but the AdvisorShares Active Bear ETF (NYSE:HDGE) has a strategy that aligns perfectly with the name of the fund. It’s an active fund managed by human beings, not pegged to an index, which seeks out bearish investments that can deliver gains to investors as underlying assets fall.

It’s an intriguing concept — not just for those looking to profit from a crash but also for folks looking for a kind of “insurance” policy for their portfolio. As the ticker symbol implies, a little bearish investing can do a great deal of good for investors simply looking to hedge their bets.

I caught up with Active Bear ETF manager John Del Vecchio this week and asked him how he operates the fund, how investors can use it and what makes him feel decidedly bearish about the current environment.

Q: Your active management style sets this ETF apart from conventional “inverse ETFs.” Can you explain the difference?

A: We focus on individual stocks that we believe have risk of missing earnings or reduced guidance primarily because management is acting aggressively with its accounting. In addition, we determine our exposure based on our view of the market with respect to how overbought or oversold it is, valuation, and whether investor sentiment is at extremes. This allows us to build a portfolio of securities that we think over time will work well on the short side. As our opinions change on stocks or the market, so will the composition of the portfolio.

An inverse fund is linked to an index, such as the S&P 500. Also, some of them are levered. We do not use leverage, nor are we linked to an index. We feel we have an advantage because if the S&P 500 does experience a correction, it will be driven by companies such as Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), Johnson & Johnson (NYSE:JNJ), General Mills (NYSE:GIS), etc., which make up a large portion of the index. Do you really want to short Apple, which is a market leader, or Johnson & Johnson, which has a huge dividend?

Neither do we.

Q: The Active Bear prospectus says the fund selects short positions in securities with low earnings quality or aggressive accounting intended to mask operational deterioration. Do you think that strategy is easier or harder than picking “good” stocks?

A: Nothing is “easy” in the stock market. But our process has been in use and refined over 13 years. I think my view of the world is that I like to catch people with their “hand in the cookie jar.” I’m wired to enjoy finding a stock that goes down 30% because management overstated revenues [rather] than try to find the next big winner that goes up 300%. In addition, most stocks are losers over time. What happened to Kodak, Polaroid, General Motors (NYSE:GM), Bethlehem Steel, all of which were huge companies in the 1970s? They’re all dead money. The same thing happened with the big Internet stocks. They haven’t done much for over a decade.

Q: It sure would have been nice to have had HDGE as an option during the 2008 crash, but the fund only recently launched, in 2011. Was this ETF a direct response to the market volatility after the financial crisis or was it something that came about separately?

A: I used to manage short portfolios as a private partnership into 2010. The idea for HDGE came from taking our process and making it available to everyone rather than just a few investors.

Q: Do you see this ETF as a profit vehicle, a “hedge” as the ticker implies or a bit of both?

A: Both. Everyone needs insurance. We get it for our cars and home (hopefully), but many people seem to forget it when it comes to their portfolio. Yet the stock market is far more likely to blow up several times than your house is likely to burn down. So for a slice of your portfolio, we think it makes sense as a good hedge.

Then, as you get bearish, you can ratchet up your exposure. Then it becomes less of a hedge and more of a profit vehicle.

Q: Right now, your biggest short positions are Goodyear, OpenTable and Energizer. Tell me a little bit about why these stocks look like bad news.

A: OpenTable (NASDAQ:OPEN) has aggressive revenue recognition and loose terms extended to its customers, which indicates that those customers are under duress or risk of going bankrupt. There’s also deceleration in many of the metrics we follow. Many of Open Table’s customers may be closed for business sooner rather than later.

We think Goodyear (NYSE:GT) will have a bad year. Volumes and margins are under pressure. When the top line is under pressure and you can’t pass along rising input costs to customers, your entire income statement gets squeezed. Cash flow is weak and getting worse. Debt levels are high as well. Companies with heavy leverage and experiencing secular declines in their business are going to be under a lot of pressure. We think GT is one such company.

Energizer (NYSE:ENR) is experiencing greater competition in the face of stagnant organic growth. Earnings are being managed by cutting expenses at a time when greater investment is needed, in our view, to benefit the business longer term. Instead, management is focused on short-term EPS goals. Without an acceleration of organic growth (you can only cut expenses so much), we think the bunny runs out of juice in 2012.

Q: Big picture, what do you think is the biggest risk to the market right now that could affect all stocks negatively in the months ahead?

A: I wish monetary policies weren’t being used to target asset prices. I’m not convinced people “feel wealthier” and spend more because the S&P 500 is at 1,400. People need and want jobs. Higher-paying ones, too. That makes them feel wealthy and spend more.

So all of this intervention only leads to much bigger declines when the air is let out of the balloon. I think we have several more years of tremendous volatility in the markets.

Q: As a manager of a short fund, do you ever find yourself actively rooting against the market or against individual stocks?

A: Nope. I don’t care whether the market goes up or down because over time, if we just pursue our process we will be fine. We have the best interests of our shareholders in mind as we make portfolio decisions. As far as individual stocks, I also don’t care whether they go up or down. The stock is nothing more than a way for us to express a bearish bet that the company is acting aggressively by, say, understating their expenses.

In this regard, we’re playing blackjack. We’re holding 19, and the dealer is showing a 6. The dealer turns over a 10 and has 16 and has to hit. He might pull a 4 or 5 and beat us, but the odds aren’t in his favor. It’s the same thing with stocks in our portfolio. The companies may turn their businesses around or the chicanery was a one-quarter aberration, but across an entire portfolio, I’ll take our odds every time.

If you’re buying stocks right now, you’re very late to the party. Sentiment is extremely bullish among advisors, the market is incredibly overbought, volume is dreadful, 52-week highs have been contracting, retail investors have no insurance (as measured by inverse fund volume), etc.

So the biggest risk is that we’re going to have a much more violent downdraft than people expect. What’s holding the market up right now is very, very fragile.

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