Exchange Traded Concepts, the Oklahoma City-based ETF sponsor
behind the "ETF In A Box" concept, filed paperwork with U.S.
regulators to market an equities ETF that relies on forensic
accounting to pick stocks based on the quality of their
earnings.
The Forensic Accounting ETF (NYSEArca:FLAG), as the name
suggests, applies forensic accounting principles to a universe of
500 large-cap stocks in an effort to "red-flag" companies with
accounting or performance issues and exclude them from the mix.
In the end, the fund is a long-only basket of roughly 400 stocks
deemed to have solid earnings quality. The securities are graded on
those earnings, and ranked according to that grade rather than
being ranked by market capitalization.
Forensic accountant John Del Vecchio is behind the Del Vecchio
Earnings Quality Index that was created for this ETF. Del Vecchio
is also the portfolio manager for AdvisorShares' Active Bear ETF
(NYSEArca:HDGE), a short-only portfolio that also relies on
forensic accounting, among other criteria, to select its
stocks.
Del Vecchio is hoping FLAG will find a solid niche among
investors who have watched too many companies cook the books to the
detriment of shareholders. Indeed, recent fraud-ridden downfalls
such as Peregrine Financial's are an example of the increasingly
important role forensic accounting plays in markets today.
"Our expertise in using forensic accounting at the core of our
investment analysis has already been validated for ETF investors on
the short side," Del Vecchio said in a press release. "They will
soon have the opportunity to capitalize on our earnings
quality-based strategy in a long-only index structure too."
To be clear, FLAG is not a long-only version of the actively
managed short-only HDGE, but both funds rely on Del Vecchio's
expertise.
Portfolio Construction
The companies that are selected from the original pool of 500
large-cap stocks are awarded a grade based on their earnings
quality, and those that get an "A" make up 40 percent of the
portfolio.
Other grade-level stocks such as "B," "C" and "D" each make up
20 percent of the pie. Securities are equally weighted within their
grade levels. Grades are calculated monthly and the index is
reconstituted twice a year.
"Companies determined to have overstated revenue, underestimated
expenses, generated unsustainable sources of cash flow, or that are
otherwise viewed as underperforming are given the lowest grade and
are excluded from the index," the filing said.
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