It is frequently said that there is an exchange-traded fund (or ETF) for just about every sort of investment strategy. There are even some ETFs with strategies that are either hard to understand or are elusive. Thursday is bringing the launch of an ETF we are in deep admiration of. It is way too soon to say that this will be a success, but the effort is one that is long overdue.
Exchange Traded Concepts has launched The Forensic Accounting ETF (NYSE: FLAG), based upon the DelVecchio Earnings Quality Index that was developed by Index Deletion Strategies to avoid companies with aggressive accounting practices and for investors to more easily invest in firms with high-quality earnings.
The FLAG ETF is called the first exchange-traded fund to take advantage of company specific financial statement analysis. What will drive the success here is the trading volumes. It is a strategy that should work, but some ETF families thrive and others flop, and in some cases it has to do with marketing more than it does over the quality of the funds.
With a rating system just like junior’s school report card, the ETF eliminates S&P stocks with poor accounting grades. That will automatically eliminate some of the high-flyers and key momentum stocks, but it also hopefully will avoid the implosion candidates as well. The ETF uses forensic accounting at the individual stock level and aims to identify the red flags and to identify those candidates with financial strength.
The DelVecchio Earnings Quality Index tracked by FLAG is a rules-based index that applies proprietary forensic accounting analysis to a universe of U.S. large capitalization 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. At completion, the analysis assigns a letter grade to all companies in the large cap universe. Companies graded lowest are not included in the index, while the remaining firms make up the index. The constituents of the index are weighted based off a methodology that favors higher graded companies.
We would note that the FLAG ETF launch almost seems to be the inverse of Del Vecchio’s AdvisorShares’ Active Bear ETF (NYSEMKT: HDGE). This strategy has been in the works for three months or more, and Index Universe covered it as well. CNBC’s Herb Greenberg, who is often very aggressive in pointing out many red flags on corporate governance and accounting, also opined on this new ETF launching today. Greenberg said:
Using an algorithm created by fund manager John DelVecchio, and an index aptly called the DelVecchio Quality of Earnings Index, the fund rates stocks in the S&P 500 on a scale of “A” to “F”, based on earnings quality.