New Forensic Accounting ETF avoids aggressive accounting practices

Feb 4th, 2013 | By | Category: Equities

The Forensic Accounting ETF (FLAG) has become the latest exchange-traded fund (ETF) to begin trading through Exchange Traded Concepts‘ private-label ETF platform. The fund has been listed on the NYSE Arca and invests in companies with high-quality earnings while avoiding those with aggressive accounting practices, so-called red flags.

New Forensic Accounting ETF (FLAG) avoids aggressive accounting practices

The new NYSE Arca-listed Forensic Accounting ETF (FLAG) overweights companies with high-quality earnings while avoiding those with aggressive accounting practices.

The fund tracks the Del Vecchio Earnings Quality Index, a rules-based index applying proprietary forensic accounting analysis to a universe of 500 US large capitalisation stocks.

The analysis focuses on areas including revenue recognition practices, inventory treatment, profit margins, material changes to operating expenses or income and financial ratio adjustments.

Essentially, the analysis assigns a letter grade to all companies in the universe. Companies graded lowest are excluded from the index, with the remaining firms making up the index. The constituents are then weighted by earnings quality rather than market capitalisation, thereby favouring high-quality companies. Companies receiving the top-ranking grade comprise 40% of the index.

J. Garrett Stevens, CEO of Exchange Traded Concepts, said: “FLAG seeks to track an index of stocks based on the science of forensic accounting. The proprietary accounting analysis at the individual stock level identifies financial weakness – so-called red flags – and financial strength. We believe FLAG, which seeks to reduce the investment risk in equities, is a unique and timely ETF for investors.”

The index was created by forensic accountant John Del Vecchio, principal of Index Deletion Strategies (IDS), the firm behind the index. Del Vecchio is also the co-author of ‘What’s Behind the Numbers’, subtitled ‘A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio’, which provides an insight into the philosophy that underlies the Del Vecchio Earnings Quality Index.

The index has 400 holdings, the top five of which are Owens-Illinois Inc, Avery Dennison Corp, Chesapeake Energy Corp, Allegheny Technologies and Marathon Petroleum Corp. Notable exclusions include Chipotle Mexican Grill Inc, Green Mountain Coffee Roasters Inc and Fossil Inc. Of these, Green Mountain perhaps best highlights the advantage of the index’s forensic-based strategy. It shares fell from over $100 in 2011 to below $20 in 2012 as concerns were raised about dubious accounting techniques, most notably relating to the overly eager recognition of earnings.

The fund charges an annual expense ratio of 0.85%.

For investors wishing to explore this kind of approach further, the actively managed short-only AdvisorShares Ranger Equity Bear ETF (HDGE) is worth a look. This NYSE Arca-listed fund is co-managed by Del Vecchio and specifically shorts companies with low earnings quality and aggressive accounting practices.

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