This ETF Scores by Getting Forensic

A couple of weeks ago one of my InvestorPlace associates and I were discussing the implications of Apple (NASDAQ:AAPL) being such a large part of so many exchange-traded funds. The downside of indexing is that we get the good with the bad. Therefore, the same ETFs that benefited from Apple’s big run-up are now suffering because of its disproportionate weighting.

That’s one of the reasons I like equal-weighted indexes, which don’t tend to play favorites. As part of this discussion with my colleague, we wondered if there were any new areas of interest to explore in ETF investing. With well over 1,200 exchange-traded products on the market, it would seem every investment angle has been taken.

However, in a recent article in the Globe and Mail, Martin Mittelstaedt brought to my attention a new ETF that uses forensic accounting to rate the quality of a company’s earnings. With the S&P 500 as its base index, The Forensic Accounting ETF (NYSE:FLAG) uses a five-step investment approach to rate each of the 500 companies based on earnings quality. While other earnings-driven ETFs are available, this one strikes me as unique for several reasons.

Many popular market cap-weighted ETFs are simply bets on the top 10 holdings (maybe even the top two or three) rather than on an entire sector or industry. It’s faux diversification.

Mittelstaedt points out that over half the components of the Russell 3000 underperformed the index in 2012. Even worse, a third lost money while the index itself was up 14%. Clearly, a few companies are doing most of the heavy lifting.

FLAG looks for, well, red flags about earnings in order of importance: aggressive revenue recognition, inventory issues, reserve concerns, large changes in operating expenses, large changes in operating income and tax issues. After evaluating each, it comes up with a grade from “A” to “F.” Those flunking out are excluded from the fund.

The top 100 (“A” grade) are equal-weighted and represent 40% of the portfolio. The next 100 get a “B” grade and represent 20% of the portfolio. The same applies for stocks rated “C” and “D.” Although the quality of earnings criteria are subjective, it’s really a very simple concept.

Care to guess what the top holding is by weighting?

Avon Products (NYSE:AVP), at a weighting of 0.477%, which this week had a 20% bump in its stock price due to better-than-expected earnings. The second-highest weighting as of Feb. 12 is Marathon Petroleum (NYSE:MPC) at 0.458%. Interestingly, Marathon’s exploration and production sister company has a weighting of only 0.199%, which would suggest its quality of earnings rates a lowly “D” grade.

A couple of other points: First, the index is reconstituted monthly. Each of its 500 companies  is regraded, and if a company falls to an “F,” it’s removed and replaced with a higher-rated stock.

Second, unlike all the other ETFs based on the S&P 500, FLAG actually removes the 100 biggest stinkers from the index. WisdomTree’s Earnings 500 Fund (NYSE:EPS) uses fundamental weighting based on earnings momentum over the past four quarters to construct its portfolio, but it still invests in the entire index. This is what makes FLAG truly original.

As ETFs go, this is about as innovative as they come. John Del Vecchio, the creator of the Earnings Quality Index, which FLAG seeks to replicate, believes that by dropping the 100 lowest-rated stocks, it provides investors with a shorting strategy without actually having to short anything. It’s a brilliant observation.

The ETF world needs to adapt new ideas, and this is one of the best to come around in a long time.

Many investors are going to read about this fund and then skip over it because liquidity is limited and the expense ratio is high 0.85%. My advice is to forget both of these concerns and give it a try — because the rationale behind FLAG is spot on.

As of this writing, Will Ashworth didn’t own any securities mentioned here. 

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