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'Shark Tank's' O'Leary dives into smart beta ETFs

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He's popularly known for being a tough judge of business pitches and fledgling entrepreneurs on network television. But Kevin O'Leary assumed the starter role for his own venture into ETFs this month, partnering with FTSE Russell to launch the O'Shares FTSE US Quality Dividend ETF, the first in a series of five smart beta funds.

O'Leary is not an asset management novice, however; his Canadian fund manager O'Leary Funds offers several categories as well as closed-end funds. The O'Leary Canadian Bond Yield Fund was awarded by Lipper for having the best risk-adjusted performance in its category over a three-year period.

O'Leary spoke with Money Management Executive about the role his celebrity status plays in promoting the new ETF, as well as his views on product development and the efficiency of rules-based systems.

Why launch an ETF?

I was trying to solve my own family trust. I have a trust that I set up in 1997 and it's designed very specifically to take care of a unique set of circumstances.

I've decided that for my own family, I am going to do what my mother did for me - they're only going to get capital from birth to last day of education, and then they get nothing. Then their children can get taken care of.

When I set it up I put some mandates on it; 50% fixed income and 50% equity. Since the decades have gone by, one of the challenges I've had is style-drifting and managing the equity side.

I'm an old school, very conservative guy. I look at long-term trends over the last 40 years - 70% of returns came from dividends and not capital appreciation, so I don't want to own it in stocks. You don't pay dividends ever, so that's just one of the rules put in place.

So there are 1,700 ETFs, and I hired a bunch of guys do the research and said, find me a bunch of candidates to look at and they whittled it down to 50.

But all of those 50, which are very good have been around a long time with good track records, but what's happened to them is they're market cap weighted. So, what occurs is; stocks that are phenomenally successful in one decade or a 5-year period end up being an inordinate-sized ETF, because that's how ETFs were first structured. They're indexes with no rules.

So you end up with an ETF that has eight stocks that represent 68% of the whole thing, which I don't want to invest in. That doesn't work for me, because if you look over long periods of time - remember, this trust is going to go over multiple generations - it has got to work after I'm gone.

I said there must be a different way to do this and I started talking to the FTSE Russell guys. I asked about their index, and described what I wanted.

There were three metrics I wanted. I like low vols, so I said give me something that has 20% less volatility - go back test it 10 years and give me names that pay dividends of 20% less volatility, which I put in places with less risk.

I also want to test the balance sheet because if you look at technology over the last couple decades, there have been a lot of accruals in income. I want cash-based earnings. So, the companies are growing cash, but I don't want them using leverage, so if a guy takes on debt to pay me a dividend, I don't want that either. So, I want quality, I want low volatility that has to pay a dividend; those are trade rules. That's a new generation of index that puts in place that rule. Plus I put I capped them at 5% weighting, so it allows new names to come in as they generate income.

So we start the gain with about 142 names that have been mined out of the entire market using these rules. There's no index like it on earth. It got a lot of interest in its first day, and I think in the end all that matters is performance.

My strategy for my own trust is to buy on the equity side, which is fixed at 50% of the capital. So now I have full sectorial diversification and full geographic diversification.

The other thing about this index, and I think this is what I value the most; the S&P pays about 1.9% right now, this pays almost 3%, so I'm getting 50% more income because I have to pay out 5% to the trust every year. So, I need to generate a minimum of 5%, which I can do between equities and the fixed-income side because that's paying for the kids, the extended family, all the charities we committed to years ago.

When you make commitments like that, nobody thinks about whether you're going to pay or not, you just have to pay.

So, this thing has become more and more of a problem for me every year and this is how I am going to solve it. That was the genesis for this whole thing, and that start was of a lot of interest to a lot of people because it turns out a lot of people had the same problem.

Adding your name certainly brings attention to this fund.

There's no question that this helps marketing. But, in the end, this is my second firm in financial services - I also have O'Leary Funds - but publicity doesn't help in the long run. What matters is performance. If you can't perform, and you don't do it cost efficiently it doesn't matter.

People know me for being a value-yield investor. Anybody that knows me on 'Shark Tank' knows that I do structures that return capital. That's what I do and I tell people the truth about it. Sometimes they have a hard time with the truth, and that doesn't really matter to me because the truth is still the truth. Money is binary. Either you make it or lose it. Your ideas are either good or they are not.

I simply look at this remarkable metric, and I didn't really stumble upon it. When I was a kid my mother was pounding me, "Never spend the principal, only the dividend." That was her whole thing. She would never buy a security that didn't have a dividend yield or interest.

After she died I became the executive of her estate. She had a hidden account from both of her husbands that she kept. All it had in it was large-cap dividend paying stocks and corporate credit, so I saw the returns over 50 years. It was stunning.

She wasn't a portfolio manager. She simply had this intuitive feeling about market risk and spent the interest on the dividends. So leave it.

That's a lesson in life. I saw that happen and said, give me the data. If this is true, it's going to show up. And that's when I dug back and just looked at the North American market. Over 40 years, 71% of returns were on dividends, not capital appreciation. That was it for me. I'm done. I'll never buy a stock this big again. I just never will. So, to me it's a speculation that it doesn't pay a dividend.

So, I look at it and say to myself, these are metrics based on sound financial principals over a long period of time and that's why I should build a product this way and not worry about the month to month gyrations. As long as the company's passing the test on the balance sheet side, I should be okay.

What's your forecast for smart beta?

I think it's going to be very disruptive over the next 36 months to five years because I think at the end, the more institutional the mandate is, the more conservative it is, and the more you're going to push towards a rule-based mandate.

If you look, since 2008, at the volatility of the market, we've had some periods of extreme volatility - equities and fixed-income down 38% and ripping back up to 24 months to another 60%.

While that kind of volatility is not what any institution wants - nobody wants to manage that because it's extremely high, because in most mandates you're paying out are somewhere between 4% and 7% annually; whether it's a pension plan, a family office, a trust - you're trying to manage for low volume and income.

To add insult to injury, these losers charge high fees – 12 of the 20 have expense ratios over 1%.
August 9

In the end, the way an institution or the way I did it - I hired a team to research all of the mandates available looking for things that I have to have - that's the evolution of the ETF market. It's people trying to solve specific problems and then those mandates get reviewed and scrutinized by analysts who decide whether they're appropriate for what that institution is doing and I think that's what people are going to do when they look at the O'Shares family. They might say, 'I know what he is trying to do,' or, 'Some portion of that fits.'

But the difference now is the market cap of international stocks with dividends has gotten really interesting. You can get $50, $60, $70 billion foreign stocks in every sector paying dividends. [And for] the companies that people generally don't own; domestic mandates are becoming interesting because their fees are lower.

I think the rule-based system works because, it's agnostic to me. It just keeps testing the market every day for opportunities that actually fit the rules. I don't know of a better way to do it. That way you take out the emotional aspect of a manager. None of that happens. You simply keep looking at the rules, testing the balance sheets, looking at the free cash flow and either bringing the name in or out of the mandate on the quarterly or an annual basis. I can't think of a better way to run institutional money.

What's next for investment firms?

The really interesting debate that's going on with these institutional and trust managers' family offices is can the Internet somehow democratize the fee structures in all of these mandates? Can there be a way that you can manage - let's say you have a mandate for $250 million and you have to pay out the 5%.

Well, traditionally you would go to a large bank or institution and go through a series of fee reductions on whether it be fixed-income or managed index, or whatever. I think what the market is struggling with is trying to find a way, in the same way the Internet has been so disruptive to retail - look at the what's happening at Amazon, which is a very cost-effective way to buy retail products - can it do the same thing for institutional and large-scale mandates?

All of the electronic trading platforms, for example, have taken the average trade down from $90 to $9 in the last 15 years - that really hasn't happened yet in institutional management. We will all use the banking structures. We still work with FX desks and hedged out currency risk, and I think that's probably the next frontier. It's just taking a whole lot longer than people thought, because if I want to hedge a European investor, if I put $10 million into the European name, and I want to hedge up the next two quarters of its dividend yield against the dollar, I really can't do that online. I mean there are services that I could, but I wouldn't because it's a large position, I want it attached directly to the securities held, and there's certain cost to it.

I bet you there's some guy in a basement somewhere saying I'm going to try and aggregate all of this on a platform somewhere and provide this service at a 70% discount.

After Lehman's collapse, the fixed income market, even after Dodd-Frank, is-actually less liquid today. Go figure. I don't think we helped anything. 

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