What good is professional skepticism and financial statement literacy if you can't (ethically) make a few bucks off of it? Exchange Traded Concepts is aiming to do exactly that by trying to "avoid companies with aggressive accounting practices and invest in firms with high quality earnings." It's the first such ETF of its kind:
"FLAG seeks to track an index of stocks based on the science of forensic accounting. The proprietary accounting analysis at the individual stock level identifies financial weakness – so called red flags – and financial strength," says J. Garrett Stevens, CEO of Exchange Traded Concepts. "We believe FLAG, which seeks to reduce the investment risk in equities, is a unique and timely ETF for investors."
Here's how it works: 500 large-cap stocks are weighted by earnings quality with a grade from A – F based on the DelVecchio Earnings Quality Index methodology developed by John DelVecchio, CFA. Those in the highest earnings quality make up 40% of the index with the B, C and D earnings quality stocks receiving a 20% weighting. The 100 bottom-dwellers are ignored from the index.
The analysis focuses on areas including revenue recognition practices, inventory treatment, profit margins, material changes to operating expenses or income and financial ratio adjustments. At completion, the analysis assigns a letter grade to all companies in the large cap universe. Companies graded lowest are not included in the index, while the remaining firms make up the index. The constituents of the index are weighted based off a methodology that favors higher graded companies.
In other words, the index is trying to avoid stocks exhibiting "aggressive accounting" and stick to tried-and-true safe bets. Which should basically be every single publicly-traded company following GAAP audited by a PCAOB audit firm but we all know how that goes.
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