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.

Forensic Accounting can be enhanced through the use of a long/short structure. This way, you're capturing the best financial trends while also seeking to profit from the worst. Short positions add value, because when accounting goes wrong, it can go really wrong. While outright frauds are few and far between, earnings misses and the reduction in expectations can really sink a stock and negatively impact your portfolio.

Investors then get a boost from this index enhancement. By carving out a piece of a large-cap U.S. equity allocation and enhancing it through the use of an alternative weighting methodology that focuses on corporate honesty, you may be able to improve your portfolio’s risk/return profile and give investors greater peace of mind.

References

  1. Wienberg, Christian, August 13, 2015. "GN Shares Drop as Headset Sales Fall, Accounting Fraud Detected," Bloomberg Business. Referenced from: http://www.bloomberg.com/news/articles/2015-08-13/gn-shares-drop-as-headset-sales-fall-accounting-fraud-detected

Disclosures

This article is for informational purposes only, and is not an offer or recommendation to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular trading strategy. Further, none of the information and material in this article is intended to constitute legal advice, tax advice, investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Additionally, nothing herein shall be deemed to constitute an offer or a solicitation of an offer to provide advisory services to any person in any jurisdiction where such offer or solicitation would be unlawful or otherwise prohibited. Historical data and analysis should not be taken as an indication or guarantee of any future performance, analysis, forecast or prediction. Investing involves risk. Principal loss is possible. Note: It is not possible to invest directly in an index.

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