FLAG: Forensic Accounting In An ETF Wrapper

by on February 20, 2013 | ETFs Mentioned:

As the ETF landscape continue to grow and evolve, investors can now choose from a lineup of over 1,400 products that offer exposure to nearly every corner of the investable universe. From traditional plain-vanilla funds to products that utilize compelling methodologies, issuers continue to pump out innovative ETPs year after year. Forensic accountant John Del Vecchio, and creator of the Del Vecchio Earnings Quality Index, recently took the time to discuss the Forensic Accounting ETF (FLAG), and how investors can take advantage of this unique strategy in their portfolios [see Free Report: How To Pick The Right ETF Every Time]. 

ETF Database (ETFdb): What was the inspiration behind creating the forensic accounting ETF Forensic Accounting ETF(FLAG)?

John Del Vecchio (JDV): The inspiration behind FLAG is several fold. When I was an intern in college I worked for James O’Shaughnessy, author of What Works on Wall Street. While there I helped test strategies back to the 1950′s and I was struck at the fact that investing in the S&P 500 is a very poor strategy relative to others that we tested (it was about in the 30th percentile). Yet, most managers underperform the S&P, as we know. The S&P 500 is capitalization-weighted in large domestic stocks. That is the strategy and it’s applied consistently, which is why it likely beats most active managers that have no consistent approach [see S&P 500 Visual History]. 

Then I went off to become a short seller where I cut my teeth with a leading forensic accountant. I learned techniques to uncover “red flags” that were warning signs of potential earnings manipulation. And, I developed my own techniques as well.

When I saw a study by Blackstar Funds that showed from 1983-2007 that most companies underperformed the Russell 3000 index and a significant portion lost money despite the wind at investors back and the index being up almost 900%, I put 2 and 2 together and developed FLAG.

Source: Blackstar Funds

Source: Blackstar Funds

The problem with traditional indexes in my mind is that they are market capitalization weighted (which is inferior to other strategies) and they include not only the very best stocks, but also all of the losers. And, in capitalism most companies are going to fail. Eventually their stocks will too [see ETF Performance: Weight Isn't Everything].

So, FLAG applies financial statement analysis to kick out the companies with sufficient red flags that suggest they may underperform the index. It then weights them based on earnings quality rather than market capitalization. There’s a whole host of red flags, and I recently co-authored a book published by McGraw-Hill called What’s Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio that outlines most of what I know.

ETFdb: What is the objective of FLAG and how does it actually work?

JDV: The objective of FLAG is to outperform the S&P 500 by exposing the fundamental flaws of index construction. That is, most companies underperform the index they are in by a sufficient margin as market capitalization weighting, based on my experience testing hundreds of strategies, is relatively weak.

It works by assessing a company’s earnings quality and deleting the companies with “red flags” that may lead to inferior returns. For example, the index pays particular attention to the quality and sustainability of revenue and whether management may be overstating revenues for short-term gain. In my opinion, revenues are more important than earnings because if a management team is engaging in chicanery to overstate the top-line, it directly relates to the demand for their product, which is likely softening. It doesn’t matter whether they sell software, tennis shoes, or widgets!

Once the financial statements have been analyzed, each stock is scored and graded A-F just like a report card grade in school. The F’s are deleted from the index and the rest are weighted according to earnings quality with the A’s overweighed. The index will have approximately 400 large cap domestic stocks. It’s updated once a month, as new financial information is available in the public domain.

ETFdb: What separates FLAG from other equity ETFs on the market that employ screening methodologies in an effort to refine a broader index?

JDV: Fundamental indexes often reweight the S&P 500. Whether they do it by revenues, dividends, or some other way, they still include all of the losers. Thin about it. In the 1970’s, the leading companies were Polaroid, Xerox, Eastman Kodak, General Motors and the like. Then it was Microsoft, Dell, Cisco, and Intel. Today it’s apple and Google. Rarely does the leader of one market cycle stay the leader in the next. The index goes up, but there’s a lot of losers, and they often suffer greatly before being kicked out of the index!

Other strategies often use screens and have a cut off factor such as highest relative strength. But, that only really works depending on timeframe, market value, and how a company is capitalized. Plus, it’s arbitrary to take the top 50 stocks, for example [see 10 Questions About ETFs You've Been Too Afraid To Ask].

FLAG reconstitutes an index of 500 large capitalization domestic companies by earnings quality and then takes the extra step to exclude those the model believes are the most likely to underperform. Accounting is the language of business. No other ETF is approaching indexing from a forensic accounting basis. Most people have never been dedicated short sellers or read through thousands of SEC filings either.

ETFdb: How might FLAG fit into a portfolio? Would you consider this as a core equity holding, or more tactical?

JDV: Great question! Both.

If you own the S&P 500 or any other index, you cannot possibly outperform it since there’s a cost associated with holding it. FLAG is designed as an enhanced index fund by providing the potential for excess return using the same stocks that are in the benchmark index. So, in that sense it’s a core holding to enhance index exposure.

A more sophisticated investor could create a hedge fund like product. FLAG seeks to generate the alpha of a short seller without shorting any stock (short selling scares most people) by excluding the potential ticking time bombs. So, you could buy FLAG and then short an S&P futures contract (or S&P 500 ETF) and capture the quality spread that it creates because FLAG is over-weighted companies with high earnings quality. But, you also get downside protection with the hedge. If the FLAG does it’s job well and boots enough big losers from the index before they crater, then a respectable risk-adjusted return can be achieved. But, you don’t have to pay some hedge fund manager huge fees or have your funds tied up in lock-up periods.

Bottom Line: Traditional market capitalization weightings were once the only game in town, but in recent years alternative methodologies have become more popular among investors who find flaws in a strategy that gives the most weight to the biggest companies. The creators of FLAG have embraced this concept, offering up a compelling strategy that utilizes forensic accounting to give investors the biggest bang for their buck. 

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Disclosure: No positions at time of writing.