Thursday, February 21, 2013

"Forensic Accounting ETF" (FLAG)

From ETF DataBase:

FLAG: Forensic Accounting In An ETF Wrapper
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....MORE
HT: I think it was Abnormal Returns but can't recall which post.
The most accessible intro to Forensic Accounting is still  Howard M. Schilit's Financial Shenanigans.