FlexShares, the exchange-traded fund arm of Northern Trust, has introduced currency-hedged versions of two existing smart beta ETFs. The ETFs provide dollar-hedged exposure to either developed or emerging markets stocks, with the portfolio tilted towards size and value factors.
Shundrawn Thomas, Head of Northern Trust’s Funds and Managed Accounts Group.
Shundrawn A. Thomas, Head of Northern Trust’s Funds and Managed Accounts Group, commented: “International equity exposure is a core element of many portfolios seeking long-term growth as developed markets allow investors to expand their opportunity set beyond US borders. Our research shows that employing a tilted approach to capturing size and value factors potentially adds value to global equity strategies.”
The case for factor tilts can be traced back to Fama and French whose 1992 paper highlighted that over 90% of a stock’s variability could be explained by three factors: the return of the market, a premium relating to the size of the firm, and a premium relating to the value characteristics of the firm.
Traditional hypotheses have stated that smaller firms may be more risky than larger firms, due to a smaller customer base, less access to finance, and inexperienced management, for example. As such, these stocks need to command a higher premium to compensate for the extra risk.
Value investing may have outperformed historically due to the style’s preference to back firms with attractive fundamentals, such as those with low price-to-book or price-to-earnings ratios.
Although these strategies have outperformed the general market on average historically, they may underperform in certain market environments. FlexShares addresses this by combining both tilts within each ETF to add diversity and smooth the volatility of returns that may be experienced under a one tilt strategy. The new ETF offerings from FlexShares go a step further by offering currency-hedging to reduce the oftentimes highly volatile nature of currency returns.
“Currency fluctuations add complexity when implementing an international strategy, especially during times of monetary intervention. By hedging the currency exposure in a tilted strategy, the resulting portfolio may provide optimal exposure while reducing potential volatility from currency fluctuations,” added Thomas. As such, one-month currency forward contracts are employed to minimise exposure to adverse movements in currencies relative to the US dollar.
The FlexShares Currency Hedged Morningstar DM ex-US Factor Tilt Index Fund (NYSE: TLDH) tracks the Morningstar Developed Markets ex-US Factor Tilt Hedged Index. As of 10 November 2015, the fund was distributed between large-cap (56.2%), mid-cap (14.7%) and small-cap (28.7%) holdings. There was a 43.0% allocation to firms considered to be characterised as ‘value’ holdings. Major country exposures were in Japan (26.0%), the UK (19.0%), France (7.5%), Canada (7.5%) and Germany (7.0%); while major sector exposures were in financials (26.0%), industrials (15.0%), consumer discretionary (15.0%) and consumer staples (9.0%). There is a net expense ratio of 0.47% due to fee waivers scheduled to remain in place until November 2016.
The FlexShares Currency Hedged Morningstar EM Factor Tilt Index Fund (NYSE: TLEH), tracks the Morningstar Emerging Markets Factor Tilt Hedged Index. As of 10 Novemeber 2015, the fund is currently invested in large-cap (40.9%), mid-cap (22.4%), small-cap (30.5%) and micro-cap (6.2%) companies; while also maintaining a current distribution between value stocks (44.1%), core stocks (31.7%), and growth stocks (24.2%). The fund has major country exposures to Hong Kong (28.0%), South Korea (16.0%), Taiwan (14.0%) and India (8.0%); and is currently invested in the financials (26.0%), information technology (17.5%), consumer discretionary (12.0%) and industrials (10.0%) sectors. The fund carries a net expense ratio of 0.70% due to fee reimbursements in place until November 2016.
Both indices are reconstituted on a semi-annual basis while each fund follows a quarterly rebalancing schedule.