Forensic Accounting ETF is an option available to investors for enhanced indexing, which can mimic actively managed styles.
According to ETFTrends.com, exchange traded funds are moving beyond their traditional beta-indexing methodologies. The recently launched Forensic Accounting ETF (FLAG) adopts a five-step approach to rank each of the 500 companies forming part of S&P 500, based on earnings quality.
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Traditionally ETFs track an index such as a stock index or bond index. It offers several benefits such as low costs, tax efficiency and stock-like features.
Such a broad market approach might be popular for many. However, for those who are looking to adopt a more concentrated look at large cap stocks, one can filter the vast canvas through various parameters such as earnings quality or cash flow quality. However companies can be smart enough to cover up subtle weaknesses.
Broadly, scanning through these issues is popularly called ‘forensic accounting’. This process involves looking for a number of red flags that can emanate signals such as weak earnings quality, inventory problems besides accelerated revenue recognition.
FLAG Tracks Red Flags
According to forensic accountant John Del Vecchio, the developer of FLAG’s underlying Earnings Quality Index, he analyzes numerous financial statements for each company to determine to what extent their revenues and earnings are overstated, expenses are understated or cash-flow quality is deteriorating.
As these are considered ‘red flags’ signaling warning signs to investors, the ticker symbol of Forensic Accounting ETF has rightly been coined as FLAG.
John also acts as the co-portfolio manager in another actively managed fund, AdvisorShares Ranger Equity Bear ETF (HDGE). This fund aims to achieve capital appreciation through shorting domestic stocks.
The fund follows a lettering system to rank companies based on their earnings quality. For instance, 40 percent of the index is assigned for companies having highest earnings quality, while B, C, and D earnings quality firms get only a 20 percent weighting. However, the fund disregards the 100 least promising stocks from the index. The portfolio manager also excludes the group of stocks falling under F category.
The F-rated companies have some glaring red flags such as rising inventories coupled with moderate revenue growth, lower sales trends, falling margins, besides high amounts of revenue from unbilled receivables signaling aggressive revenue recognition.
The A-rated stocks are characterized by strong balance sheets, solid cash flow, sustainable buy-backs and dividends, besides rising gross profit and EBITDA margins.
A closer look at FLAG’s March 30th portfolio composition reveals its top 10 holdings are held in prominent companies such as Hewlett-Packard Company (NYSE:HPQ), SAIC, Inc. (NYSE:SAI), DIRECTV (NASDAQ:DTV) each garnering 0.45 percent of assets.
Forensic Accounting ETF Flags For Various Financial Ratios
The Forensic Accounting ETF also has flags for various financial ratios. For instance, average price/earnings ratio has a flag set at 13.52, while average price/book has a flag at 1.80.
The fund also has the following sectoral weightings. Consumer cyclical, industrials and financial services sectors occupy the top three slots having flags respectively set at 13.23, 13.06 and 12.76 respectively.
Thus, Exchange Traded Funds have certainly moved away from their traditional approach by adopting enhanced indexing approach.