ETF Expert Corner

Transcript

You can listen to our interview with Brad Lamensdorf by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: The ETF we're spotlighting this week is the Active Alts Contrarian ETF, ticker symbol SQZZ. This just launched back in March. It's the first actively managed ETF investing in companies with large short positions outstanding, and so those companies may be prone to a so-called short squeeze. You can see where the ticker symbol for this ETF came from - SQZZ “squeeze” - great ticker. Joining us via phone from Westport, Connecticut to discuss this ETF is the Founder and President of Active Alts, Brad Lamensdorf. Brad, great to have you on the program today.

Brad Lamensdorf: Hey, thanks for inviting me.

Nate Geraci: Brad, before we get to the ETF, let's first define a few terms here that some investors may be unfamiliar with. What does it mean to take a short position in a company?

Brad Lamensdorf: Good question. So a short sale is when you're betting against the company, when you think the stock price is not worth what it is today, it'll be lower later. Maybe it's a coal company, that you think coal is totally out of fashion, so you sell it short at $10. It falls to $5. You purchase the shares back, and you make a profit of 50%. Unfortunately, this style of investing can lead to unlimited losses. So if they were wrong and the stock went from let's say $10 to $30, they would've lost $20 off of their $10 capital investment. So this definitely has unlimited loss potential.

Nate Geraci: And not to get too far into the weeds here, but how would somebody actually go about executing a short sale?

Brad Lamensdorf: So, mechanically, you have to call your broker. You have to borrow, physically borrow the shares. They write it down and give you a confirmed number of the shares that they've lent you. Then you instruct that same broker to sell what you've borrowed into the marketplace, and then you've now just initiated a short position. The only way to extinguish that position, would be to what's called cover short, which would be to buy.

Nate Geraci: Now, I know this can vary widely depending upon the stock, but generally speaking, what does the average short position outstanding look like for commonly held stocks? What's considered normal?

Brad Lamensdorf: Normal is about 1.4% short on the average stock in the United States.

Nate Geraci: Okay, so keeping that in mind, now explain for us what a short squeeze is.

Brad Lamensdorf: Sometimes there are companies - and let's take something from the way past or even future or we could do something as of present - so when we launched the fund, one of our favorite stocks was Weight Watchers. It was a $14 stock about a few months ago, and 60% of the outstanding shares of the corporation were short. So there are lots of people betting against Oprah Winfrey, or funds, hedge funds most likely, that whatever they see is going on with the company is not good. They're betting for lower prices. We looked at the balance sheet, we looked at a lot of what was going on with the company. We felt like things were doing extremely well. We took the opposite bet, which was a long position of $14. It went to $24 before we even knew what had happened. A lot of that, again, is people with unlimited loss that are just covering, knowing that they're wrong, pushing the stock even higher. We exited at around $24. I think it's even at $33 as of today, and I still see a pretty decent short position of about 25% of the company. So a lot of people have been covering from that 62% when they first got bearish on it in the teens.

Nate Geraci: Is there typically a catalyst for a short squeeze - perhaps a good earnings report, a new product announcement, something along those lines? Or can sentiment just change that rapidly?

Brad Lamensdorf: Well, it depends. Maybe there are some energy stocks that are perfectly good companies, but energy is in the dumps. So a lot of these companies could just move up with higher prices, just all of a sudden. But usually, you're going to get a corporate action, a new President, a new CEO, new management. Sometimes a company, for instance, we're looking at a company called Chegg (CHGG), it's a 30% short. We've been in it since the ETF started - about $8. It's about $13 now. And they've bought two privately held education companies, merged them into this current company that they have, which is basically an online educational tutoring site. And, in conjunction with all of that, the management team was able to move to digitized book leasing from hard copy back, hard books that they were getting from McGraw-Hill and it completely changed the margins of the business. So when they had an earnings announcement, they blew out their quarter a lot more so than I guess everyone expected. But a lot of the times, you can see a lot of these changes occurring if you're paying attention. Sometimes a lot of these shorted companies are just legacy shorts. For instance, Blackberry is also still a heavily shorted stock, even though they've been performing very well - they won that huge lawsuit, they've got a lot of cash on their books now. Almost 40% of the company is cash, but yet 10% short position remains in the stock. So there's a lot of opportunity in the area for sure.

Nate Geraci: Our guest today is Brad Lamensdorf, Founder and President of Active Alts. We're spotlighting the Active Alts Contrarian ETF, ticker symbol SQZZ. Brad, let's talk specifically about this ETF. In essence, you're betting against the short sellers. You're seeking to invest in companies with good fundamentals, but that have large short positions outstanding. High level, what does the process look like here? How do you determine which companies to own in the ETF?

Brad Lamensdorf: That's a good question. So we can own anything with a market capitalization of $250 million and greater. Usually, it needs to have a pretty liquid profile, a daily profile. I don't want to get into something that's too illiquid. And once we have screened those specific names, those specific types of illiquid names out of our universe, we then run another screen which basically gives us every stock that's over a 10%, has 10% of the float short. And then we also, from another source, get a list of all of the companies, and this is opening up another can of worms, but all of the most expensive stocks to borrow. Because sometimes when you borrow a short, like I mentioned earlier in the program, sometimes it doesn't cost you anything. For instance, IBM is a very large company. There are millions and millions of shares outstanding. So when you call your bank up to borrow something, they literally are going to put it into your account and then they will charge you what's called general collateral, which is traditionally free pretty much. But there are times where people gang up on some of these shorts, like I mentioned, and the banks create a profit center out of lending stock in street name out to hedge funds that are short sellers that want to partake in a short position. So some of these can be upwards of 10, 20, 30% a year interest that these short sellers are paying to borrow the shares. What we do is we have a list of the highest interest borrowed shares so that we want to take a look at those as well because hedge funds are obviously paying quite a bit to borrow them on an annualized basis. For instance, Sanchez Energy, which is a stock we're long, short sellers are currently paying almost 38% a year to borrow those shares. So you could only make 100% on your short, because it can only go to zero. So that's quite a bit of interest to be paying when you think about it philosophically.

Nate Geraci: And so Brad, if I could just to boil this down. This ETF is offering two primary return streams. Obviously, you have the stocks in the portfolio that might produce out-sized returns due to short squeezes, and then the second piece that you're hitting on is something called securities lending. And it's a fairly common practice in the ETF space, but you seek to specifically maximize the income generated by this, correct?

Brad Lamensdorf: Right, and the way that I'm maximizing it isn't necessarily doing anything that anyone else isn't doing. I'm just completely 100% fishing in the very, very high rate market because I see an opportunity to a) I can pick fundamental stocks through any universe that I'm given, that's my job. And since we specifically focus on stocks that a) have large short interests embedded in them and b) that we can lend for extra interest. So for instance, Sanchez, we get that daily interest hitting our NAV every day when we're lending that security out. Obviously, most of them aren't at negative 38% a year or 38% a year for the SQZZ ETF toward us, but there's plenty of 3 and 5 percenters along the way that should generate very nice income as you mentioned, and that interest will hit the dividend yield quarterly.

Nate Geraci: With that income on the securities lending side, are there any specific risks that investors should be aware of as it relates to securities lending?

Brad Lamensdorf: The biggest risk for securities lending is if you feel like your firm that you're lending them to could go out of business. We use one of the top five brokerage firms in the world, so I hope they don't go out of business. But we are collateralized with cash, so when we lend our securities out, they're having to give us cash to securitize that stock that they've borrowed. So we're very, very collateralized in what we're doing.

Jason Lank: Brad, this is Jason Lank, welcome to the program. On the subject of cash in terms of the construction of the ETF, my understanding is that the ETF can hold quite a bit of cash at any given time, perhaps even up to 100% of the fund. Is that the case and why would the ability to do that be important?

Brad Lamensdorf: So, it's very important. My background, I used to work for the Bass brothers in Fort Worth, Texas, and thereafter I ran a long-short hedge fund. It was extremely successful. One of the things that we were very, very good at doing was not allowing ourselves to get too emotional about the market. So when sentiment gauges get really, really high, when the insider selling - like it is right now - is very, very high, we like to back off the market and use that cash as a hedge. So while the fund doesn't go short, we do back off of the market when we think it's too charged, and when things are looking worse than they probably are, is when we use that extra cash to put money back to work in a good opportunistic fashion.

Jason Lank: Brad, earlier in the show, in an earlier segment, we discussed the possible challenges active managers face like the paradox of skill and the shrinking number of securities available, the rise of quantitative strategies. You're betting against the short sellers who are perceived in some quarters to be pretty savvy. Make the case for us for your active approach given some of these potential hurdles.

Brad Lamensdorf: So, one of the best arguments for active management - so active and passive have cycled quite a bit throughout the decades, so this frankly nothing new - I know that we all remember the 2000 period where there was actually a bear market in value from 1997 to 2000, and literally, if you were not in technology, you were literally down two straight years in a row, 98 and 99 versus the technology that was really pushing everything up. What we saw was a prelude to a bear market, just the last group was really holding everything together before the 03 correction occurred, 02 correction. In our opinion, a very similar situation is occurring now, where a lot of groups are out of gear, you have a lot of the REIT stocks already falling off dramatically. The retail market, as far as stocks have been concerned, have been pretty dismal as well. So you have a lot of groups and stocks that are already starting bear markets, and within all of that trading are, as you mentioned, different types of players. Quantitative players, a lot of different type of people coming in and doing things. These quantitative people - I saw actually something recently that said 90% of all trading is now quantitative in computer programs. But that actually aids too the active manager at a certain point, because if somebody has figured out a program and they say, "Listen, if we take these names and we get them together every month and we rebalance, we can beat the market by 5 or 8% a year every year." And that's great, except that they're blindly creating strategies without really doing a lot of deep down work and what we find is, is we don't know who would ever be shorting a lot of Chegg’s, for instance - CHGG, the stock that I had mentioned earlier. But maybe it's some computer program that just looks at free cash flow or negative free cash flow and says, "Short everything that has negative free cash flow." Here, that's creating an opportunity for me because they're acting blindly, and whereas I'm looking to cherry pick, it helps me because obviously I want to take the opposite position.

Nate Geraci: Brad, we have about one minute left here. Where does the Active Alts Contrarian ETF fit in an investor's portfolio?

Brad Lamensdorf: So, the ETF is going to have quarterly dividends. The dividends should be quite enhanced from the securities lending business that we do on top of the normal dividend flow that we get. So it's going to be producing income, and on the other side, it's going to have some capital appreciation opportunities. So either bucket probably is a pretty ... I would probably say that the market capitalization is not large cap, it's probably much more mid cap range.

Nate Geraci: Well Brad, with that, we'll have to leave it there. Very interesting ETF. We certainly wish you all the best, and thank you very much for joining us on the program today.

Brad Lamensdorf: Thanks so much for having me.

Nate Geraci: That was Brad Lamensdorf, founder and President of Active Alts. Again, the ETF is the Active Alts Contrarian ETF, ticker symbol SQZZ, and you can learn more about this ETF by visiting activealts.com.