Why Active ETFs Are Doing So Well: AdvisorShares CEO

Noah Hamman isn’t about to weigh in on the always-controversial active versus passive debate.

The founder and CEO of Active ETF provider AdvisorShares Investments thinks it’s rather moot, and sets his sights on a bigger target.

“I’m not trying to convince anyone that an active ETF is better than a passive ETF,” he says, when asked to pretend the interviewer is legendary passive investment advocate John Bogle, the Vanguard founder. “I’m instead looking at the $13 trillion in mutual funds, 80% of which are actively managed, and telling them there is a better way.”

He notes that when passive ETFs were introduced, passive strategies could be gotten from many different sources. It was the transparency, liquidity and accessibility that gave them their unique value proposition.

“It’s the same now with active ETFs. You can get active management anywhere, but active ETFs are more liquid, transparent and have a lower cost than comparable products.”

And of course, there’s the product’s tax efficiency, especially when compared with its mutual fund counterpart.

“For these reasons, active ETFs are attracting more assets at this stage of their development than passive ETFs did at the same point in theirs,” he adds.

Hamman points to the number of new products coming available as proof of their popularity, despite recent regulatory hurdles like a moratorium on derivatives.

Hamman knows a little something about the active ETF and alternative investment space. In 2006, he was an equity founding partner of Arrow Investment Advisors, advisor to the Arrow Funds. In the first 24 months of operation, Arrow had $350 million in assets under management and distribution relationships with firms including Merrill Lynch. Before that, Noah was vice president of business development for Rydex Investments.

Giving credence to his active/passive peace plan, Hamman notes that at Rydex, he led the launch of the firm's index-based ETF, commencing with the launch of RSP (Rydex S&P Equal Weight ETF). In addition, he diversified the firm's business and product lines by developing the firm's first buy-and-hold mutual funds.

As for the near-future for active products, Hamman sees a particular type of advisor as the key.

“It will be the fee-based advisors that will drive their growth in large part,” he concludes. “The commission-based people will still go for more of A-share and C-share mutual funds, but for the former, it fits.”

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Breaking Down Financial Securities Licenses

So, you've decided to sell investments. Whether you want to be a registered representative (RR) or an investment advisor, the first step in either process is obtaining the proper securities license. The license needed is determined by several factors, such as the type of investments to be sold, method of compensation and the scope of services that will be provided. In this article, we'll examine the different types of licensing and show you how to determine which license is right for you.

FINRA Licensing Breakdown
The Financial Industry Regulatory Authority (FINRA) oversees all securities licensing procedures and requirements. This self-regulatory organization administers many of the exams that must be passed to become a licensed financial professional. It also performs all relevant disciplinary and record-keeping functions.

FINRA offers several different types of licenses needed by both representatives and supervisors. Each license corresponds to a specific type of business or investment. While there are several licenses geared toward specific types of securities, there are three general licenses that the majority of representatives and advisors usually obtain:

Series 6
The Series 6 license is known as the limited-investment securities license. It allows its holders to sell "packaged" investment products such as mutual funds, variable annuities and unit investment trusts (UITs). The Series 6 exam is 135 minutes long, and covers basic information regarding packaged investments, securities regulations and ethics.

This license is also required for insurance agents that sell variable products of any kind, because securities constitute the underlying investments within those products. Principals who supervise representatives holding a Series 6 license must obtain the Series 26 license in addition to having already obtained the Series 6.

Series 7
The Series 7 license is known as the general securities representative (GS) license. It authorizes licensees to sell virtually any type of individual security. This includes common and preferred stocks; call and put options; bonds and other individual fixed income investments; as well as all forms of packaged products (except for those that also require a life insurance license to sell). The only major types of securities or investments that Series 7 licensees are not authorized to sell are commodities futures, real estate and life insurance.

The Series 7 exam is by far the longest and most difficult of all the securities exams. It lasts for six hours and covers all aspects of stock and bond quotes and trading; put and call options; spreads and straddles; ethics; margin and other account holder requirements; and other pertinent regulations.

Those who carry this license are officially listed as "registered representatives" by FINRA, but they are generally referred to as stockbrokers. Many insurance agents and other types of financial planners and advisors also carry the Series 7 license to facilitate certain types of transactions inherent in their businesses. Principals of general representatives must also obtain the Series 24 license.

Series 3
The Series 3 license authorizes representatives to sell commodity futures contracts, which are generally considered the riskiest publicly traded investments available. Representatives that carry the Series 3 license tend to specialize in commodities and often do little or no other business of any type.

The Series 3 exam is approximately 120 minutes long and covers all forms of commodities transactions, options, hedging, margin requirements and other regulations. An offshoot of this license is the Series 31 license, which allows representatives to sell managed futures (pooled groups of commodities futures similar to mutual funds).

NASAA Licensing Breakdown
Not all securities licenses are administered by FINRA. The North American Securities Administrators Association (NASAA) oversees the licensing requirements of three key licenses:

Series 63
The Series 63 license, known as the Uniform Securities Agent license, is required by each state and authorizes licensees to transact business within the state. All Series 6 and Series 7 licensees must carry this license as well. The provisions of the Uniform Securities Act are tested on the 75-minute exam.

While this test is much shorter and covers less material than the FINRA exams, it is known for asking "trick" questions that force the candidate to definitively know the difference between which transactions and situations are permitted and which are required by the rules. This test also contains some experimental questions that the NASAA uses to gauge future relevance.

Series 65
The Series 65 license is required by anyone intending to provide any kind of financial advice or service on a non-commission basis. Financial planners and advisors that provide investment advice for an hourly fee fall into this category, as do stockbrokers or other registered representatives that deal with managed-money accounts.

The exam for this license is a 180-minute exam that covers the rules and regulations pertaining to registered investment advisors, as well as various investment vehicles and disciplines, economics, ethics and analysis. Much of the material is covered on the Series 7 exam as well, as many of the advisors who sit for this exam are not, and may never become, Series 7 licensed and therefore need exposure to the investment material covered therein.

Series 66
This Series 66 is the newest exam offered by NASAA. In essence, it combines the Series 63 and 65 exams into one 150-minute exam. This test contains no investment material, as the Series 66 license is only available to candidates that are already Series 7 licensed.

Making the Grade
Most securities exams administered by both FINRA and the NASAA have a passing score of 70%, except for the Series 7, 63 and 65, which have passing rates of 72%, and Series 66, which has a passing score of 75%. All tests are now given via computer at approved proctor testing sites.

Broker-Dealer Sponsorship Vs. RIA Requirements
Once all relevant securities tests have been taken and a passing grade received, licensees must register their securities licenses with an approved broker-dealer, who will hold their licenses and oversee their business (in return for a portion of the commission income). Those who intend to hold themselves out to the public as Registered Investment Advisors (RIAs) must register with the state they do business in if their assets under management are less than $25 million, or with the SEC if the assets exceed $25 million. Registered Investment Advisors do not need to associate themselves with a broker-dealer.

Company Policy
The majority of financial and investment companies that hire or train new advisors will have a mandatory licensing program included in the training package. The company will, in most cases, mandate which licenses must be obtained to sell the company's products and services. Those that decide to go into business for themselves still need to meet the licensing requirements of their chosen profession; the only real freedom of choice comes in which profession is chosen.

Don't Get Too Worked Up Over Fabrinet's Earnings

Although business headlines still tout earnings numbers, many investors have moved past net earnings as a measure of a company's economic output. That's because earnings are very often less trustworthy than cash flow, since earnings are more open to manipulation based on dubious judgment calls.

Earnings' unreliability is one of the reasons Foolish investors often flip straight past the income statement to check the cash flow statement. In general, by taking a close look at the cash moving in and out of the business, you can better understand whether the last batch of earnings brought money into the company, or merely disguised a cash gusher with a pretty headline.

Calling all cash flows
When you are trying to buy the market's best stocks, it's worth checking up on your companies' free cash flow once a quarter or so, to see whether it bears any relationship to the net income in the headlines. That's what we do with this series. Today, we're checking in on Fabrinet (NYSE: FN  ) , whose recent revenue and earnings are plotted below.

Source: S&P Capital IQ. Data is current as of last fully reported fiscal quarter. Dollar values in millions. FCF = free cash flow. FY = fiscal year. TTM = trailing 12 months.

Over the past 12 months, Fabrinet generated $35.6 million cash while it booked net income of $61.3 million. That means it turned 5.7% of its revenue into FCF. That sounds OK. However, FCF is less than net income. Ideally, we'd like to see the opposite.

All cash is not equal
Unfortunately, the cash flow statement isn't immune from nonsense, either. That's why it pays to take a close look at the components of cash flow from operations, to make sure that the cash flows are of high quality. What does that mean? To me, it means they need to be real and replicable in the upcoming quarters, rather than being offset by continual cash outflows that don't appear on the income statement (such as major capital expenditures).

For instance, cash flow based on cash net income and adjustments for non-cash income-statement expenses (like depreciation) is generally favorable. An increase in cash flow based on stiffing your suppliers (by increasing accounts payable for the short term) or shortchanging Uncle Sam on taxes will come back to bite investors later. The same goes for decreasing accounts receivable; this is good to see, but it's ordinary in recessionary times, and you can only increase collections so much. Finally, adding stock-based compensation expense back to cash flows is questionable when a company hands out a lot of equity to employees and uses cash in later periods to buy back those shares.

So how does the cash flow at Fabrinet look? Take a peek at the chart below, which flags questionable cash flow sources with a red bar.

Source: S&P Capital IQ. Data is current as of last fully reported fiscal quarter. Dollar values in millions. TTM = trailing 12 months.

When I say "questionable cash flow sources," I mean items such as changes in taxes payable, tax benefits from stock options, and asset sales, among others. That's not to say that companies booking these as sources of cash flow are weak, or are engaging in any sort of wrongdoing, or that everything that comes up questionable in my graph is automatically bad news. But whenever a company is getting more than, say, 10% of its cash from operations from these dubious sources, investors ought to make sure to refer to the filings and dig in.

With questionable cash flows amounting to only -0.4% of operating cash flow, Fabrinet's cash flows look clean. Within the questionable cash flow figure plotted in the TTM period above, stock-based compensation and related tax benefits provided the biggest boost, at 8.8% of cash flow from operations. Overall, the biggest drag on FCF came from capital expenditures, which consumed 33.3% of cash from operations.

A Foolish final thought
Most investors don't keep tabs on their companies' cash flow. I think that's a mistake. If you take the time to read past the headlines and crack a filing now and then, you're in a much better position to spot potential trouble early. Better yet, you'll improve your odds of finding the underappreciated home-run stocks that provide the market's best returns.

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