There's a $129 million ETF that offers a unique safety net for investors hoping to avoid the next stock market crash. Here's how it works.

Akin Oyedele

Mar 5, 2019, 20:36 IST

There's a $129 million ETF that offers a unique safety net for investors hoping to avoid the next stock market crash. Here's how it works.

Betting against the S&P 500 through an exchange-traded fund is one way to stay afloat when the stock market goes south.
However, investors are better suited with a strategy that's not wagering against the world's largest companies, according to Brad Lamensdorf, manager of the $129 million AdvisorShares Ranger Equity Bear ETF (HDGE).
In an interview with Business Insider, he detailed how the ETF generates alpha - or outperformance - for investors during market downturns.

If investing was easy, surviving a stock-market crash would be as straightforward as betting against the S&P 500 ahead of a downturn.

However, reality dictates that making such a well-timed call is almost impossible, and it demands that investors find other ways to stay hedged against losses.

In fact, placing a short bet against the entire S&P 500 is the last thing Brad Lamensdorf advises a market bear to do. This is a big part of the reason why he helped create a novel way to stay afloat during market downturns.

"40% of the entire market cap is made up of the 40 or 50 best companies in the United States," Lamensdorf, manager of the $129 million AdvisorShares Ranger Equity Bear exchange-traded fund (HDGE), told Business Insider by phone. "Is that really what you want to be short?"

In his view, it's a rhetorical question to which the answer is clearly "no."

His methodology is decidedly more precise. Since 2011, his actively managed, short-only ETF has set out to handpick the weakest links in the stock market and bet against those instead. He susses out companies with characteristics like negative cash flow, "flawed" business models, competitive threats, merger and acquisition targets, among others.

If the broader stock market tanks and these stocks tank harder, HDGE wins. If stocks are rallying but investors sniff out the weaknesses in these companies, HDGE also wins. This two-pronged approach to hedging is why the ETF has been able to exist during the longest-ever bull market.

The approach also means it's crucial that Lamensdorf shorts companies Wall Street has indeed overpriced. Two stocks that he's wagering against are Wayfair - which competes with Amazon in the furniture market - and Harley-Davidson.

Lamensdorf's services come at a price: The expense ratio on HDGE is about 2.7%, much higher than many of the low-cost ETFs that are exploding in popularity. He attributes about 200 basis points to the broker fees associated with borrowing shares for short sales, and about 150 basis points in management fees.

To gauge whether HDGE holders are getting their money's worth, it's benchmarked against the S&P 500.

But this yardstick comes with an important caveat: HDGE is not designed or intended to be used as part of a long-term, buy-and-hold strategy like an S&P 500 index fund. After all, the ETF's lifespan coincides with a historic bull run and, as expected, it has been walloped by the broader stock market.

That's why Lamensdorf recommends fund managers use HDGE as a 5% to 15% layer on top of an existing portfolio of equities, depending on how aggressive a hedge is needed at the time. This way, a portfolio manager can generate alpha if their strongest convictions crush the market and profit via the short sale of beaten-down names.

For example, HDGE emerged 3% ahead of the market in 2018 while the S&P 500 declined on an annual basis for the first time since the recession. And, over the last five years, it has slumped 11% on an annualized basis, besting the typical bear-market fund, which lost 17% over the same period.

But not everyone who uses HDGE is a market bull with a contingency plan. According to Lamensdorf, some traders simply want to make a directional bet that stocks will fall. One common way to do this is through an ETF that's designed to mirror an index like the S&P 500 or the CBOE Volatility Index (VIX).

However, the implosion of products like the VelocityShares Daily Inverse VIX Short Term exchange-traded note demonstrate the danger of products wholly pegged to a specific underlying security. In highlighting the danger of inverse ETFs, Lamensdorf pointed to Vanguard's announcement in January that it would stop accepting purchases of such instruments.

"We're as simple as it comes," Lamensdorf said. "We short stocks. We don't use leverage, we don't have options, we don't use derivatives ... we don't have anything except we're short an equity security."

Also, Lamensdorf says that timing the market - or just knowing when to beef up hedges - is a daunting task. He's observed that HDGE gets a flood of inflows when a market correction is already underway. But by then, much of the complacency that preceded the sell-off has usually been shaken out of investors' psyches.

In other words, it's too little, too late.

To mitigate against this kind of reactionary emotional behavior, Lamensdorf publishes a Market Timing Report that combines various sentiment gauges, including the Ned Davis short-term indicator, to help this cohort of investors monitor the risk of losses on a six to nine-month basis.

"What I traditionally am looking for is extremes that I can react to," Lamensdorf said of his newsletter. "And the extreme that we had in December has almost moved from as desperate as anybody can get to as bullish as anybody can get now. We're back to kind of 'La La Land' levels on many of my gauges."

In other words, it might be an opportune time to start putting on some hedges.