An ETF Fit for a Shark: OUSA Q&A with Kevin O'Leary & Connor O'Brien

We recently had the opportunity to talk with the two men behind O’Shares, who took us under the hood of OUSA’s unique methodology, as well as an inside look at the issuer’s pipeline.

ETF Database (ETFdb): Tell us about yourself and the company.

Connor O’Brien (CO): I met Kevin O’Leary in 2007, he’d been on television a little bit at that time, and I knew that his visibility would help build a mutual fund company. In 2008 we created O’Leary Funds and it’s been profitable since day one. We focus on profitable companies that pay dividends. We like profit.

For the last 3 years or so, Kevin (O’Leary) and I have done an annual study of ETFs to evaluate if it’s an area we should get into. Because Kevin has gained so much visibility (through Shark Tank being aired on ABC and CNBC), we knew his visibility would solve one of the key challenges in the industry. Simply put, it’s hard to create a differentiated product. And if you can’t get enough people to look at it, you can’t grow or be profitable. You need high conviction to get traction.

ETFdb: What is the biggest ETF industry trend you expect to play out in the next 3-5 years?

Kevin O’Leary (KOL): There is no doubt that evolution and innovation will continue, and needs to continue. Investors will demand ETFs designed to meet their objectives, not simply follow generic indexes. Years ago, all ETFs were generic market cap weighted portfolios. Innovation then began, with very simple rules-based ETFs, such as portfolio weighting based on a single metric such as revenue, yield or volatility.

As an investor, I don’t want to own companies just because they have big revenues, or big dividends. I want to own portfolios built using an intelligent set of rules, such as Quality, Volatility and Yield, as well as liquidity and market cap. Although rules-based indexing (“smart-beta”) is not new, it is becoming more advanced. I believe it will gain traction with individual and institutional investors globally, and I plan to be very involved in the evolution of ETFs.

As you watch O’Shares expand, you will see innovative smart-beta ETFs for equities, fixed income and asset allocation strategies. We plan to provide investors with simple, practical, value-added tools to build better portfolios. We also look forward to educating individual investors globally on the efficiencies and benefits of using ETFs. We are very focused on this area, financial literacy and education. As you know from ABC’s Shark Tank, I’m the only shark who will tell the truth!

ETFdb: Will the O’Leary Family Trust own the hedged, unhedged or some combination of both of the Europe and Asia-Pacific dividend funds?

KOL: My family trust has specific income objectives and long-term needs. It needs to distribute 5% annually and I want to protect and grow the Trust for a long time, long after I am dead, and preferably forever. Since diversification is a very powerful investment tool, my plan is to invest in every ETF that O’Shares develops.

We will soon have five O’Shares ETFs using the Quality, Low Volatility and Yield rules-based strategy developed by our team with FTSE Russell. We will have one O’Shares ETF investing in Europe with currency hedged back to the US dollar, and another unhedged with exposure to currencies including the Euro, Swiss Franc and British pound. Our ETFs investing in Asia-Pacific equities will provide investors a similar choice.

Right now, we have a strong US dollar and a weaker Euro and Yen due to central bank easing in Europe and Japan, so I expect a larger initial allocation to the currency hedged ETFs. But I expect my Family Trust will invest some amount in both currency choices to get some currency diversification, because I am a disciplined investor.

ETFdb: There are close to 100 dividend-focused ETFs on the market, some of which target the same three factors the O’Shares FTSE US Quality Dividend ETF (OUSA) does. What makes OUSA’s screening methodology different?

CO: We set out to create a set of large-cap dividend strategies that would solve for Kevin’s investment needs – specifically the needs for his family trust. Kevin wants the trust to last forever – long after he’s gone. He also wants the trust to generate more than 5% a year and to grow its capital.

OUSA follows this criteria – its objective is to generate income of at least 1.5x that of a generic index, keep volatility risk metrics at 20% less than a generic index, and we also wanted to see strong performance. If you take a look at some of the large cap indexes, you see that relatively simple rules guide it – we wanted to see a method that would “think” a bit more.

In regards to the ETF’s dividend screening methodology, we focus on strong dividends as opposed to extremely high yields. We believe a good dividend payer does not have to have a high yield – in fact, most high yielding dividend stocks will fail on our other screening metrics.

ETFdb: Under the quality screen, what are the key factors and criteria you look at? What do you look at in your volatility screen?

CO: Balance sheet quality and earnings quality. On the earnings quality side, we look at accrued revenue (many of the large cap failures in history had a lot of accrued revenue), WorldCom for example. We believe cash is king, meaning cash earnings is better than accrued earnings. Additionally, a strong cash balance sheet reduces net debt, which improves a company’s balance sheet quality score. In general, companies that have a lot of cash tend to have better earnings quality. We also avoid very leveraged companies. For volatility, we look at multiple time frames, including as far back as 5 years.

ETFdb: Currently, OUSA allocates roughly 15% of total assets to pharmaceuticals and biotechnology stocks. Are there any industry or sector specific caps?

CO: No, the industry and sector allocations are the result of screening, scoring, and market capitalization — a blended weighting. Certain sectors have companies that are predominantly underweighted, though you will find the top scoring companies in those sectors included in the portfolio. Conversely, even if a particular sector typically scores higher, we will not give heavier allocations to individual companies in that sector that score lower.

ETFdb: In the SEC filing, you mentioned launching four more quality dividend products, which apply the same methodology to equities from Europe and Asia Pacific. Given the current global economic landscape and the fact that these funds are geared toward long-term investors, what is your outlook on these two regions?

CO: Europe is ever so slowly following the Fed, gradually getting onto the right path though at a much slower pace than the United States. We think Europe is going to gradually do better, particularly European exporters in light of a weaker euro. Additionally, the region is more or less getting through the Greece situation; the issue has been solved in a manner that is going to throw cold water on other countries trying a populous, left-leaning “wiggle out of national debt" approach. Overall, we think European success will come gradually.

In Asia Pacific, we see quantitative easing (QE) coming out of several major economies — including Japan and China. We think Asia will see a multi-year benefit from QE, as the U.S. has. The region is also different than Europe in terms of currency — we see several dominant currencies such as the Australian Kiwi and the Japanese Yen doing better. And once China manages to re-position its economy using QE, we believe the region will benefit in the long run. It is important to note, however, that none of our Asia Pacific ETFs will include Chinese equities, since the underlying index focuses only on developed countries.

ETFdb: Why have you decided to create currency-hedged and non-hedged versions of the Europe and Asia Pacific funds? Who would you recommend own the hedged vs. non-hedged versions?

CO: We think that people who do not have confidence choosing to have euro or Asian currency exposure will buy our hedged-products. But for those that want currency diversification in their portfolios, the non-hedged versions are more appropriate. When in doubt, however, stay with hedged products.

ETFdb: There is a lot of talk about the fact OUSA (and the region-specific lineup) are built to be a portion of the O’Leary Family Trust, does this mandate limit O’Shares ability to launch funds that help achieve a broader set of investment objectives than those of the Trust?

CO: Kevin actually has many capital pools besides the family trust. And while we will see more product development that is suited to the trust and geared towards ultra long-term conservative investors, we will be looking to expand the lineup — perhaps focusing on more growth objectives for those investors with shorter time frames. O’Shares intends to work with top tier index partners, and will only launch new products once we are convinced it adds value to a broader set of the public. We will, however, stay true to our dividend focus.

ETFdb: What is your stance on dividends vs. buybacks?

CO: We are looking closely at that. We believe getting cash back to investors is a very important ingredient. Dividends are typically more constant and tend to grow. Buybacks, however, are less constant.

ETFdb: What are some of O’Shares’ long-term objectives in the ETF industry?

CO: Our objective is driven by bringing out high quality investment products. If investors remain interested, we will continue to develop useful strategies. In the next 60-90 day time frame, we will have five products on the market. We expect to bring out another set of products in the second and third phase.

Though having a name like Kevin O’Leary behind an ETF is compelling on its own, investors who take a close look under the hood of O’Shares’ unique methodology will find that OUSA could be a viable and promising core-holding for any long-term portfolio. And with four new Quality Dividend ETFs on the way, O’Shares may just become the next big fish in the ETF pool.

Disclosure: No positions at time of writing.