Q:  What is the history of the fund? A : The Active Bear ETF (HDGE) is an actively-managed exchange-traded fund, which was launched in January 2011 on the AdvisorShares platform, is the first actively managed ETF with a U.S. stock short strategy. The fund is sub-advised by Ranger Alternative Management, L.P. Q:  Would you underscore the benefits of the exchange-traded fund structure? A : We launched the Active Bear ETF (HDGE) as an exchange-traded fund because we felt that there was a much broader need for people to have access to shorting individual stocks without financial leverage or derivatives. The ETF vehicle provides total transparency while removing any hidden risks. With this structure we offer liquidity during market hours unlike mutual funds, which offer only one price after market hours, as well as total transparency in our holdings at any time, again in contrast to mutual funds, where investors do not always know what the underlying exposures are. Q:  What are the tenets of your investment philosophy? A : Our investment philosophy is premised on the thesis that we can achieve positive returns by uncovering companies with deteriorating fundamentals. Our philosophy of shorting stocks stems from the fact that most stocks actually go down over time. Several independent studies have confirmed that in the long run most stocks decline, creating valuable opportunities to short even in bull markets. As a result, we look for companies that have fundamental issues rooted in their operations, accounting or in disclosures. For example, an independent study reviewed the Russell 3000 Index from 1983 to 2006, a period known as the largest secular bull market. The market was up about 900% during that timeframe, in which 39% of the stocks were unprofitable investments, 64% underperformed the index, 19% declined by 75% or more, and 25% accounted for all of the market gains. Just as a hypothetical situation, if we were now in 1979 and looked forward 30 years saying that the likes of Polaroid, Eastman Kodak, General Motors, and Bethlehem Steel will be pretty much bankrupt, that would sound ridiculous because back then those names stood out as the leaders of the market. However, the reality is that there has been dead money for a long period of time. If we rolled forward to the late 1990s, when we had companies like Intel, Microsoft and Cisco, we would clearly see that for the last 13, 14 years there has been pretty much dead money. Those were the leaders of the Internet space but not the leaders of the market today. In this way we see that the burden is on the long manager to be heavily concentrated in the top 25% of the stocks for the market gains, otherwise they are going to underperform. Over time, we tend to be able to exploit this huge opportunity set that we have, and that is why we are short. We do not like index-based products because we do not think they offer the opportunity to generate significant returns when the market does pull back. I think there is significantly more opportunity to be within the individual stocks than within the indexes themselves. Q:  How would you describe your investment process? A : We start out by looking for companies that have aggressive accounting and are acting in a way to mask deterioration in their business. We try to find situations when the management is offering incentives to customers to essentially buy today what they would otherwise buy at a later date. To the extent that we have concerns, they are in direct proportion to where they reside on the income statement. That is how we build a list of companies that we think have earnings risk, whether it is an earning miss, a reduction in guidance or a regulatory investigation in a more extreme case. Once we have established that watch list, we then layer on a technical analysis. We also screen for companies that are undergoing distribution in stock trading, which means that there is some selling pressure in the stock price that we can identify. That is a clue that big investors are trying to get out of the stock. We try to allocate capital when we see the selling pressure. A good example that illustrates this would be Deckers Outdoor Corporation. We had fundamental concerns about Deckers, especially related to their inventory and revenue-related items. At the time the stock was facing selling pressure which showed us that there were some growth managers who were already unloading the stock despite the strength in the overall market. Open Table Inc. is another example of a stock that in October 2011 was undergoing some selling pressure, which confirmed our fundamental view of some aggressive revenue recognition issues. The stock was declining even when the market was rebounding. My view is that if the demand for a company’s products is strong, there is no incentive on the part of management to aggressively recognize revenue or chase the revenue recognition policy or to do something that makes the business appear stronger than it truly is. I think that is the biggest tip off. Investor sentiment and the trends in the markets, on the other hand, are important to us and we use that as a gauge to dictate our overall exposure. We know statistically that the odds are in our favor by being aggressively short. We look at the bullish percent, which is the percentage of stocks that are in bullish trends using point figure charting. Those types of indicators help us in building our portfolio. Q:  What are the analytical steps that constitute your research process? A : We use quantitative research that we have developed in-house where we rank stocks by their underlying earnings quality, specifically with a focus on revenue recognition and cash flow quality. Quantitative research allows us to pinpoint areas where we want to dig deeper. Then, we look at annual and quarterly filings as well as our notes and transcripts of the conference calls to distill that down into a list of stocks that we think have the most compelling earnings risk. While we use third party research, we do not rely on Wall Street research and we do not talk to management, which always provides an optimistic view of the company and the business. For example, Open Table, our single largest position, is a provider of online reservation to restaurants for a fee that is facing a host of competitive forces. This company has a couple of revenue-related issues that raise red flags. For instance, installing their program into a restaurant was booked over a six-year period and now it is booked over a three-to-six year period. Whenever management gives a range it always means that management will pick what is most advantageous to them. That means they are booking the revenue faster than they did previously. So, for a company booking about $37 million or $38 million a quarter, 8% to 10% of revenue may not actually materialize. The other issue is that their days of sales outstanding have accelerated from the mid-30 day range into 46 days. A couple of quarters ago management indicated that when the days sales outstanding goes up it is a sign that customers are under duress or potential bankruptcy. That also creates stress on the top line or revenues and that could also potentially mean that the company could take a hit of $4 million each quarter. All in all, a total of 18% to 20% of their revenue becomes a headwind rather than a tailwind as we look through 2012. In addition, subscription revenues in North America and international markets are decelerating. What is more, their business and reservation growth rates are decelerating too, which means that the underlying business is slowing down. Either the restaurant business is generally slowing, or Open Table’s business could be slowing due to competition, the underlying industry itself or a combination of both. Presently the stock trades about $42, and we continue to believe that it will be cut in half from here, which is a considerable downside. To cite a different example, Constant Contact, Inc., a provider of email delivery services, has huge promotional activity in their business and the company has been offering $50 American Express gift cards to induce people to sign up for a trial of their services. The low-end customer pays about $15 a month to Constant Contact but they are offering a $50 incentive for $45 in revenue. In my opinion, such incentives seem to be a pretty aggressive way to acquire new customers. The range is somewhere between $15 and $30 a month based on the service plan selected. Furthermore, it is not really an addition to revenues, so we think that they are overstating their revenue growth by inducing a customer without backing that cost out of their revenue. In other words, the company’s revenue growth looks better than it really is and the customer acquisition costs appear lower than they truly are. Despite the company’s efforts, their year-over-year subscriber growth is decelerating quite substantially. It has occurred year-over-year at least for the last six quarters. In the meantime, their customer acquisition costs are skyrocketing quarter-after-quarter and now it takes them over a year to breakeven on a customer, while earlier on it used to take them about half a year. Constant Contact is a $30 stock which I think is worth probably in the low teens, but if we got into a bear market, it could well be a sub-$10 stock. Open Table and Constant Contact exist in entirely different industries but their underlying issues are somewhat the same. Q:  How do you build your portfolio? A : The portfolio has between 30 and 40 stocks on average with position sizes ranging between 2% and 7%. However, a typical holding will generally account for 1% to 4% of the portfolio. As far as diversification is concerned, we want to spread out our capital to the largest possible number of stocks that have the same underlying issues and over companies in different sectors and market cap ranges. For us, keeping the underlying issues heavily concentrated is critical because in this way we know where the odds are in our favor. In terms of exposure, we rely on sentiment, which will indicate what our overall exposure will be. If sentiment is very high and the market is overbought, we will be more focused on small and mid-cap growth companies that generally have higher volatility on the upside and the downside. If the market is oversold and the sentiment is bearish, we will be focusing on large caps that generally display lower volatility than the broader market. We look at the macro indicators in the context of price, volume of the market and inverse funds. With regard to indices, we do not really benchmark ourselves against anything. Although we do not short ordinary shares in foreign markets, we may short American Depository Receipts of foreign companies that are traded in the U.S. Q:  What kinds of risk do you focus on and how do you manage them? A : We evaluate one stock at a time and try to limit stock specific risk by controlling position sizes in the portfolio. In doing so, we prefer to scale exposure out of what is not working and adding exposure to what is working. For instance, when Green Mountain Coffee Roasters was going against us, we were cutting our exposure substantially and then, once it started to finally turn and work in our favor, we quadrupled the size.