Forensic Accounting ETF on the Horizon?

Zacks

Exchange Traded Concepts, the Oklahoma City-based turnkey ETF provider, is at it again on the fund development front, filing with the SEC for a new product. This new fund looks to be in concert with Index Deletion Strategies and will take a closer look at forensic accounting in order to eliminate the stocks with the worst earnings quality.

This approach looks to give investors a new way to avoid securities that may be running into trouble in the near future, while zeroing in on firms that have high quality and hopefully sustainable earnings, potentially reducing risk over the long term. While many details were not available in the initial filing and press release—such as expected release date or expense ratio—we have highlighted some of the key points from the two documents below:

First, investors should note that the product is being developed by John Del Vecchio, an index principal and forensic accountant, according to the press release. He is currently the manager of the hugely popular Active Bear ETF (HDGE), a fund that shorts securities based on earnings quality.

Apparently, John is now taking the other side of the coin from an earnings quality perspective, focusing in on the best for this proposed fund which looks to go under the ticker of FLAG. This looks to be done by following the Del Vecchio Earnings Quality Index, a benchmark that ranks 500 large cap stocks on an ‘A’ through ‘F’ scale (see A Primer on ETF Investing).

According to the SEC filing, each of the large cap stocks are assigned a grade based on earnings quality by looking at financial reports. In particular, firms are scrutinized for; overstated revenue, underestimated expenses, generated unsustainable sources of cash flow, among other key measures that could indicate low earnings quality.

Firms that receive the lowest rating on this front are assigned an ‘F’ and are excluded from the index, while the remaining firms find their way into the benchmark. Of these, firms that receive an ‘A’ account for 40% of assets, while those that have ratings of ‘B’, ‘C’ or ‘D’ each get 20% as well (see Create a Diversified Portfolio Using ETFs).

Securities within each grade level are equal weighted, and grades are computed on a monthly basis. Investors should also note that the components will be immediately removed and replaced if they find themselves with an ‘F’ grade, while the index looks to be reconstituted on a semiannual basis. No short exposure will be used in the fund, instead focusing in on stocks with higher earnings quality in order to achieve alpha.

While this proposed ETF won’t have any direct competition, investors should look to HDGE as a guide for how popular this product might be. If that fund is any indication, then FLAG could potentially be a popular fund, as HDGE has amassed over $300 million in AUM and sees volume more than 500,000 shares a day, making it one of the most popular active ETFs on the market today (see Three Defensive ETFs for a Bear Market).

This impressive asset base comes despite the fact that HDGE is one of the most expensive ETFs on the market today, largely thanks to the short interest expense. According to the HDGE home page, that short interest expense is 1.44%, resulting in a 3.29% net expense ratio to investors on an annual basis (read HDGE: the Active Bear ETF under the Microscope).

Given that FLAG looks to be long only and index based instead of actively-managed, its expense ratio will likely be far lower than what investors currently see with the Active Bear ETF. Thanks to this, it isn’t unreasonable to assume that, if ever approved by the SEC, FLAG could be a very popular product and a great choice for investors seeking a way to target the firms that have the highest levels of earnings quality for investment.

Follow @Eric Dutram on Twitter

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