It’s easy to love the premise of the just-launched Active Alts Contrarian ETF (SQZZ). We first started writing about it 2014, for Pete’s sake: an ETF that deliberately invests in individual stocks that are so out of favor, they’ve been shorted to the point where the mythical short squeeze might occur.
The idea is that a stock can get so over-shorted that any positive news causes so much pain to short-sellers that they give up and cover their shorts, driving the price up even further.
It’s always fun to be right on something like this, and to be the guy who zigs when the market zags. The challenge, of course, is you have to be more right than the short-sellers. With SQZZ now in the market, I thought it would be interesting to look at what the fund (which is 100% actively managed) is actually doing right now, and whether it’s poised to deliver on the premise.
First: About Squeezes
For a stock to experience a big pop, you need to have a few things:
- A lot of people shorting it
- A news event precipitating the squeeze
The first is relatively easy to suss out. Quick and dirty, I ran the short interest on all the NYSE stocks, and you can get a quick list of the stocks people really seem to hate. There are two easy ways to look at it. One is by how much of the float is actually short:
The other is by how much is short relative to an average day’s trading volume:
This latter number is sometimes referred to as “days-to-trade” because it implies, for instance, that it will take 60 normal trading days to unwind the 4 million shares of Tootsie Roll that are currently short.
When a company hits top 10 on both of these lists, you know you’ve got a real winner in the hate-race. Here, Vivint Solar takes the cake, being both 43% short and taking 31 days to theoretically trade out.
So what about the news factor? Well, there are some obvious things that can make a short’s day very, very bad: Earnings can beat, the company is announced as a takeover target, and so on.
The most recent example I can think of was the day Oprah Winfrey announced she was taking a 10% stake in Weight Watchers in October 2015. The stock was an astonishing 74% short before the announcement, and the stock shot up over 300% as the shorts ran for the doors.
Not Just Being Right
Taking the other side of the short-sellers bet has a side benefit: If you own a pile of stocks that everyone hates in an ETF, you can often make good money loaning that stock out to short-sellers who will continue the hate.
Mechanically, if I own Weight Watchers in my fund, I can make it available for a short-seller to borrow. In return for loaning him my stock, he gives me collateral (generally cash). I take that cash and invest it in something super safe, like a money market fund.
If the security is something boring, like Caterpillar—which nobody really hates—I might give some of that interest I get from the money market fund back to the person who borrowed my shares. For instance, someone borrows my CAT shares, I invest the cash collateral they give me in a money market fund paying 0.85%, and I agree to “rebate” 0.65% back to the borrower (that is in fact CAT’s rebate right now, according to my friends at FactSet).
Not Riskless, But Self-Contained
I pocket, on average, 0.20% over the course of the year for doing this, and if I ever need that CAT back immediately, well, I can recall it at any time. There’s some small risk the borrower will be a deadbeat, but then I have all his cash (generally 104% of the value of the stock loaned), so I can just go buy more. It’s not riskless, but it’s pretty self-contained.
But imagine someone comes to me wanting my Weight Watchers stock. Well, since 36% of the float is already short, it’s probably pretty hard to borrow, so instead of rebating them some of my money market interest, I can actually demand they pay me. In the case of Weight Watchers, the rebate is currently reported as being -10.59%, meaning the lender is paid 10.59% of the amount lent by the borrower
At the extreme, funds with much-hated stock generate real money from this activity. The Guggenheim Solar ETF (TAN) has consistently held some of the most hated stocks in the market. As of the fund’s last filing (August 2016), 39% of the fund was out on loan. And the fund earned 3.26% in the 12 months prior, presumably all from lending, since essentially no solar company pays a meaningful dividend. In 2012, they earned over 7% from this.
And What About SQZZ?
So in fact, there are two ways for SQZZ to make money. First, they can just plain get it right (or be lucky) and catch numerous short squeezes in the portfolio, giving them the chance for significant capital appreciation. At the same time, they can loan out these hated stocks and earn significant income, but if the fund is sitting on cash, that’s not going to happen.
With all that in mind, what does the fund actually own?
Two things immediately leap out at me here ...
First, the fund is 75% in cash. It’s actively managed, so they can do whatever they like, but it strikes me as a pretty-low-conviction start. Of course, next week, the fund could be fully invested, but SQZZ just launched, so it may be that they’re legging into their positions slowly. But for the moment, investors are paying a very hefty expense ratio (1.95%, making it one of the most expensive ETFs on the market) for a giant slug of cash. Sure, that gives the active fund manager flexibility, but if he sits on it for a year, it’s painful.
Second, many of the securities here don’t meet any traditional definition of “hated.” There’s Weight Watchers in here, but we also have firms like Oritani Financial, a $750 million regional bank in New Jersey, with just 4% of the float sold short, and that currently has a rebate higher than Disney or Apple. I’m not a bank analyst—maybe there’s some hidden story here that the manager is counting on coming to light. Or maybe they’re just convinced it’s been oversold the past year. But it’s hard to see how it’s going to get “squeezed” or how it’s going to generate any additional income.
And what about GE? I’m just not convinced GE is a short-squeeze candidate, with 1% short and two days to trade. I’m not even sure it counts as contrarian, when it’s just 10% under its eight-year high. And with a P/E of 29, I can’t even really come up with a “chronically undervalued/oversold” argument.
All About The Manager
It’s true with any new ETF idea, the proof will always be in the performance, but in this case, I think that’s doubly so. It’s not the case that SQZZ is a proxy-trade for heavily shorted stocks. It’s not an index fund chasing “shortness” as a factor for investors to make pure contrarian bets.
Instead, this is a purely active fund that happens to make contrarian bets that might or might not have anything to do with actual structural short squeezes. I wish them nothing but luck, but investors thinking this was a kind of formulaic bet on squeezes really need to look carefully—and at 1.95%, you better be pretty convinced the manager’s going to shoot the lights.
Note: I actually did call to get some reaction today, but as of this writing, they hadn’t returned any calls.
At the time of writing, the author held no positions in the securities mentioned. You can contact Dave Nadig at email@example.com.
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