Exchange traded funds are moving beyond the traditional beta-indexing methodologies. Now, investors can play the markets through “enhanced” indexing that mimic actively managed styles.
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. FLAG has a 0.85% expense ratio. [Forensic Accounting ETF Under the Microscope]
“I analyze 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,” forensic accountant John Del Vecchio, the developer of FLAG’s underlying Earnings Quality Index, said in an Investor’s Business Daily article. “These are ‘red flags’ (hence the ticker symbol FLAG).”
Del Vecchio is also the co-portfolio manager of the AdvisorShares Ranger Equity Bear ETF (NYSEArca: HDGE), which is an actively managed portfolio that tries to achieve capital appreciation through shorting domestic stocks. [ETF Focus: AdvisorShares Ranger Equity Bear]
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.
Del Vecchio explains that the lettering system ranks companies by “earnings quality with the least likelihood of chicanery.” He also excludes the group of stocks that fall under F ranking because “a few potential time bombs from any index can greatly enhance that index without changing the constituents of the index.”
“I determined this was an added benefit — as opposed to underweighting them — when I read a couple of studies that indicated most stocks under-perform the index,” Del Vecchio said in the article.
For F-rated stocks, Del Vecchio highlights some glaring red flags, such as rising inventories with moderate revenue growth, lower sales trends, deteriorating margins and high amounts of revenue from unbilled receivables, which suggests aggressive revenue recognition.
On the other hand, A-rated stocks show strong balance sheets, sold cash flow, sustainable buybacks and dividends, and gross profit and EBITDA margins are rising.
Del Vecchio anticipates FLAG will see higher turnovers, up to 30% annually, due to changes in F-rated stocks, but it is still lower many actively managed ETFs.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.