ETC Lists Forensic Accounting ETF

January 31, 2013

The market's latest addition is a 'forensic accounting' ETF that screens for earnings quality.


Exchange Traded Concepts, the Oklahoma City-based ETF sponsor behind the “ETF In A Box” concept, today is rolling out its latest ETF—an equities fund 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. The fund comes with an annual expense ratio of 0.85 percent, or $85 for each $10,000 invested.

The portfolio 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 the ETF. Del Vecchio is also the portfolio manager for AdvisorShares’ Ranger Equity Bear ETF (NYSEArca: HDGE), a short-only fund that also relies on forensic accounting, among other criteria, to select stocks.

Del Vecchio is hoping FLAG will find a niche among investors who have watched too many companies cook the books to the detriment of shareholders.

“Every company experiences a bump in the road; there’s no company that’s going to have just a clear straight trajectory of growth,” Del Vecchio said in a recent interview.

“But how the company withstands the bump in the road will have a lot to do with its management, and with its ability to sell its product,” he added. “At the end of the day, a company’s earnings quality is the most crucial metric here.”

To be clear, FLAG is not a long-only version of the actively managed short-only HDGE, which has gathered $192.5 million in its first two years. But both funds rely on Del Vecchio’s expertise.

“We seek to generate the alpha of a short-seller without shorting stocks,” Del Vecchio said. “By culling potential losers, we attempt to capitalize on the fact that most stocks underperform the market.”

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 that have overstated revenue, underestimated expenses, generated unsustainable sources of cash flow or that are otherwise viewed as underperforming are excluded from the index.

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