Vident: Raising The Flag

August 19, 2015

[The following "ETF Issuer Perspective" is sponsored by Vident.]

Remember the collapse of Enron and Worldcom? Investors have short memories, and the pain experienced from the demise of these market leaders is long forgotten. But the next fraud could be right around the corner.

In the last few weeks, GN Store Nord, a high-tech company providing hearing aids and hands-free communication, took more than an 8 percent hit to its stock price due to accounting fraud in its U.S. unit.1

Behind Numbers While market eras and leading stocks fluctuate, human nature never changes. If management teams want to paste over deterioration in their businesses, there's plenty of leeway within accounting to manipulate short-term financial performance.

Accounting is the language of business, and there are techniques to help observe mischievous management behavior. The WeatherStorm Forensic Accounting Long-Short Index (Nasdaq: FLAGLSX) is designed to analyze the sustainability of reported results.

Its methodology creates a portfolio of higher-quality stocks at lower valuations while also taking advantage of shorting lower-quality stocks at rich valuations.

The index analyzes accounting metrics that may offer evidence of management's aggressive tactics, then allocates capital toward higher-quality stocks at attractive valuations while relegating lower-quality stocks with less attractive valuations. This method is employed opposed to the traditional market-cap weighting that most indexes adhere to.

Fundamentally oriented indexes use metrics like revenue or cash flow and typically take them at face value. The WeatherStorm Forensic Accounting Long-Short Index assumes every company is guilty until proven innocent rather than assuming their reported results are accurate. The index estimates how likely it is that reported results contain indiscretions designed for deception.

For example, a company may "stuff the channel" by accelerating sales in the current quarter at the expense of future results. Or cash flow may be manipulated by unsustainable activity. Similarly, financial performance may be manipulated by understating expenses in the current quarter. This boosts short-term results but makes the company vulnerable to disappointments in the future.

WeatherStorm Capital's Head of Quantitative Research, Andrew Alden, recently redesigned the forensic accounting long-short index, seeking to magnify the value that forensic accounting brings to a portfolio. Instead of a long-only index, of 400 to 500 U.S. stocks the new Forensic Accounting Long-Short Index allocates capital more selectively. It includes 130 or so of the highest ranked stocks in terms of forensic accounting standards. This results in a higher-quality portfolio, while remaining well diversified.

Additionally, instead of simply omitting the lowest-ranked stocks, the new index shorts these stocks—providing investors with potential return enhancement if these poorer-quality stocks underperform.

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