While a broad market approach is a popular investment style
for many, some like to take a more concentrated look at large cap
stocks. One way of narrowing down the field is by looking at
This technique looks to use publically available financial
reports to hone in on aggressive accounting practices. These
bookkeeping tricks can often be an attempt by management to cover
up weakness and thus are issues that investors want to know about
before getting into a stock (read
3 Multi-Asset ETFs for Juicy Yields and
Generally speaking, finding these issues is known as 'forensic
accounting' which is a process that looks to find a number of
'red flags' which can signal weak earnings quality, and possibly
future troubles for a stock. These include, among others, the
following issues: fictitious revenue, inventory problems, ratio
adjustments, accelerated revenue recognition, and unsustainable
By identifying these issues, investors can avoid these weak
earnings companies and instead zero in on those who have high
quality balance sheets and other financial statements. While this
somewhat time consuming process can be done on a stock-by-stock
basis, it is now available in ETF form as well.
This is thanks to a new product from Exchange Traded Concepts,
Forensic Accounting ETF (
. The ETF looks to track the Del Vecchio Earnings Quality Index,
charging investors 85 basis points a year in fees for this low
earnings quality avoiding exposure (see
Can You Beat These High Dividend ETFs?
FLAG in Focus
The underlying index looks to take all 500 stocks in the
S&P 500 and grade them on a traditional A-F scale on a
monthly basis for their earnings quality. Firms that are rated
'A' make up 40% of the index, while those graded 'B' 'C' or 'D'
make up the remaining 60% of the fund (with each grade taking up
Stocks that receive a grade of 'F' are not included in the
fund, leaving a portfolio of about 400 stocks. It should also be
noted that within each letter grade, stocks are equally weighted,
giving the portfolio a tilt towards the top grade level which are
the stocks that have the best earnings quality.
For the purposes of the index, this earnings quality is
defined as the degree of sustainable earnings as reported by a
company. Some of the key areas that are analyzed with the
proprietary methodology include looking at gross profit for
reserve concerns, COGS for inventory issues, and revenues for
aggressive recognition procedures.
Can It Succeed?
The fund is based on the work of John Del Vecchio who has made
a name for himself in the forensic accounting-based investment
world. He is already the co-manager of the short-only fund
which looks to bet against firms that have low earnings quality
The Truth about Low Volume ETFs
This ETF is only of the only short focused products on the
market and costs a pretty penny at 3.3% in net expenses a year.
Still, the ETF has close to $200 million in AUM so investors have
clearly embraced the strategy for their portfolios.
Now that the ability to look at earnings quality is available
in a long-only product, we could see a similar level of interest
for FLAG despite its relatively high-when compared with products
-expense ratio of 85 basis points a year.
This will be especially true if FLAG can provide investors
with a solid level of outperformance, and if the tilt away from
low earnings quality firms can reduce volatility and improve
risk-adjusted returns for investors (see
4 Best New ETFs of 2012
If this is the case, Del Vecchio could have another winner on
his hands with the forensic accounting-focused ETF, giving more
credence and publicity to the investing style for all stripes of
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(FLAG): ETF Research Reports
ACTIVE-BEAR (HDGE): ETF Research Reports
SPDR-SP 500 TR (SPY): ETF Research Reports
VANGD-SP5 ETF (VOO): ETF Research Reports
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