ETC Plans Forensic Accounting ETF

October 22, 2012

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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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