Traditional index exchange traded funds have helped investors access broad market segments, but most are market-cap weighted, for better or worse. Still, there are some ETF options that take an alternative approach to indexing.
For instance, the recently launched Forensic Accounting ETF (NYSEArca: FLAG) utilizes a five-step approach in ranking each of the 500 companies of the S&P 500 based on earnings quality.
The ETF is part of a growing number of new strategy-based indices that mimics actively managed styles, but the ETF itself only passively reflects the “enhanced,” “smart” or “intelligent” index.
In comparison, Will Ashworth for InvestorPlace describes the popular market cap-weighted ETFs as “faux diversification” with a simple bet on the top 10 holdings.
The FLAG ETF “red flags” companies with financial weakness, such as aggressive revenue recognition, inventory issues, reserve concerns, large changes in operation expenses, large changes in operation income and tax issues. [New ‘Forensic Accounting’ ETF]
Stocks are weighted by earnings quality. Companies ranked the highest in earnings quality make up 40% of the index, whereas rank B, C, D earnings quality firms receive a 20% weighting. The 100 least promising stocks are disregarded from the index.
Specifically, the top holding is Avon Products (NYSE: AVP) at a 0.477% weighting – the company saw a 20% surge in stock price on better-than-expected earnings, followed by Marathon Petroleum (NYSE: MPC) with a 0.458% weighting.
The closest comparison may be the WisdomTree Earnings 500 Fund (NYSE: EPS), which uses a fundamental weighting methodology based on earnings momentum over the last four quarters, but it tracks the entire index.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.