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A Suite Approach to Quality Low Vol

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Investing in low volatility international stocks is often used as a defensive strategy by investors who want to participate in some of the market’s growth while potentially reducing their down­side risk. Our research has found, however, that traditional low volatility strategies may introduce unintended sector concentration and interest rate risk, among other challenges.

In this paper, we explain how screening for quality, as well as relative volatility may help address those problems. We then explain the methodology of the underlying indices that the three FlexShares ETFs within the Quality Low Volatility Suite including the FlexShares US Quality Low Volatility Index Fund (QLV), the FlexShares Developed Markets ex-US Quality Low Volatility Index Fund (QLVD) and the FlexShares Emerging Markets Quality Low Volatility Index Fund (QLVE), track in an attempt to create a suite of defensive strategies that we believe offer greater upside capture and less downside risk. 1

THE HIDDEN RISKS OF LOW VOLATILITY INVESTING

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Over the years, equity investors have learned that they must accept short-term fluctuations in stock prices in pursuit of potential long-term gains. Still, for many investors it can be difficult to stay invested in equities when the value of a portfolio declines sharply during a market downturn. In response, some defensive-minded investors are including exposure to stocks with lower relative volatility in an effort to help diversify their portfolios and potentially minimize those fluctuations— giving up some upside potential during positive markets in exchange for reduced downside risk during market declines.

Yet low volatility strategies may come with tradeoffs. They may have high portfolio turnover, as price movements can cause certain holdings to exceed targeted volatility limits. There also are risks to low volatility investing that aren’t immediately apparent. Our research suggests that traditional low volatility strategies have historically resulted in unintended sector concentration. Compounding this concentration risk, some of these sectors—such as utilities and consumer staples— tend to be most negatively affected by rising interest rates. As a result, traditional low volatility strategies may provide less upside capture and less downside protection than investors anticipate.

APPLYING THE LENSES OF RELATIVE VOLATILITY AND QUALITY

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All three funds that comprise the FlexShares Quality Low Volatility Suite are ETF’s that track a custom index and seek to provide exposure to companies that possess lower overall absolute volatility and that also exhibit financial strength and stability, which we believe are quality characteristics. For QLVD and QLVE they further refine by utilizing stocks that are designated as Large or Mid Cap. Northern Trust Investments Inc. (NTI) is the investment adviser for FlexShares ETFs.

While the processes utilized by each custom index is relatively the same, the starting index that NTI uses for the FlexShares US Quality Low Volatility Index Fund is the Northern Trust 1250 Index2, which represents 1,250 large and mid-capitalization US public companies.

For the two international funds, the FlexShares Developed Markets ex-US Quality Low Volatility Index Fund and the FlexShares Emerging Markets Quality Low Volatility Index Fund, the indices start with the Northern Trust Global Index.3 NTI first begins by pulling in all eligible securities. Securities are then grouped by their developed and emerging market classifications, with the developed market securities sorted further by their full market capitalization while eliminating all non-dividend paying stocks. Additional index size thresholds are then derived at the developed market and emerging market group levels.

All three indices respectively apply a multi-faceted Quality Score (QS) to measure a company’s core financial health and evaluate whether it may increase (or decrease) its future dividends.

THE NTI QUALITY SCORE METHODOLOGY

Based on these characteristics, each company’s stock receives a quality score and is assigned to quintiles, with quintile 1 representing the highest-quality companies and quintile 5 representing the lowest. The index eliminates all stocks in quintile 5, based on evidence that low-quality companies historically have exhibited higher volatility.

Next, the index employs several rules that we believe help create a properly diversified portfolio, including maximum overweights/underweights for any single stock, industry, sector, region or country. The index also targets a portfolio of securities with a historical beta4 of 0.65%, which due to historical research suggests that the stock has been 30% less volatile than the overall market. Another rule limits portfolio turnover to 12%.

Finally, NTI optimizes each customized index further by applying a quality tilt to the overall portfolio. This step helps confirm that there is a good representation of low-volatility stocks that also are from the higher quintiles in their respective sectors.

TARGETING US & INTERNATIONAL MARKETS

While all three funds utilize a similar process, it is the emphasis on targeting three distinct global markets that provide investors with the opportunity to potentially align with their goals and expectations of the market.

US Market Approach Ex-US Developed Markets Approach Emerging Markets Approach

TARGETING IMPROVED RETURNS AND STRONGER RISK MANAGEMENT

image of bullseye In our view, a good defensive strategy shouldn’t come at a greater cost than necessary to an investor’s long-term return targets. Our research suggests that using a quality screen during the custom index construction process may capture more of the market’s upside potential while protecting against downside risks.

What’s more, we believe that the custom index’s diversification controls may help avoid overweighting interest-rate sensitive sectors such as utilities and consumer staples. Together, these results suggest that applying a quality lens to a low volatility strategy may help to further diversify a portfolio and reduce volatility—without sacrificing returns.

CONCLUSION

Low-volatility strategies can be a helpful defensive strategy for investors who want to reduce potential portfolio declines during market downturns, while still capturing some of the gains that come during positive markets. We believe that the three FlexShares ETFs within the Quality Low Volatility Suite, incorporate our research-driven findings about the role of quality in a stock’s potential volatility, can help investors meet their risk management and capital appreciation goals.


FIND OUT MORE

The FlexShares approach to investing is, first and foremost, investor-centric and goal oriented. We pride ourselves on our commitment to developing products that are designed to meet real-world objectives for both institutional and individual investors. If you would like to discuss the attributes of the fund discussed in this report in greater depth or find out more about the index methodology behind it, please don’t hesitate to call us at 1-855-FlexETF (1-855-353-9383).


FOOTNOTES

1 The up-market capture ratio is the statistical measure of an investment manager’s overall performance in up-markets. It is used to evaluate how well an investment manager performed relative to an index during periods when that index has risen. The ratio is calculated by dividing the manager’s returns by the returns of the index during the up-market and multiplying that factor by 100.
2 The Northern Trust 1250 Index is designed to provide broad-based exposure to the US equity markets, with a bias towards large and mid-capitalization companies. In an effort to include a greater number of dividend-paying companies, a constituent limit of 1250 is used at the time of each annual reconstitution.
3 Northern Trust Global Index is designed to track the performance of the global investable equity markets covering approximately 97.5% of world’s float adjusted market capitalization. The Index’s coverage encompasses both developed and emerging markets worldwide.
4 Beta is a statistical measure of the volatility, or sensitivity, of rates of return on a portfolio or security compared to a market index. The beta for an ETF measures the expected change in return of the ETF relative to the return of a designated index. By definition, the beta of the Standard & Poor’s (S&P) 500 Index is 1.00. Accordingly, a fund with a 1.10 beta is expected to perform 10% better than the S&P 500 Index in rising markets and 10% worse in falling markets.
5 Northern Trust Quality Low Volatility Index tracks a portfolio of is designed to reflect the performance of a selection of companies that, in aggregate, possess lower overall absolute volatility characteristics relative to the Northern Trust 1250 Index (the parent index).
6 Northern Trust Developed Markets ex-US Quality Low Volatility Index is designed to construct a high quality universe of companies that possess lower overall absolute volatility (i.e. risk) relative to an eligible developed market universe which excludes the United States. An emphasis is placed on a company’s income and capital growth, while also reducing overall volatility of returns relative to the eligible universe (the parent index).
7 Northern Trust Emerging Markets Quality Low Volatility Index is designed to construct a high quality universe of companies that possess lower overall absolute volatility (i.e. risk) relative to an eligible developed market universe which excludes the United States. An emphasis is placed on a company’s income and capital growth, while also reducing overall volatility of returns relative to the eligible universe (the parent index).


The FlexShares US Quality Low Volatility Index Fund (QLV), FlexShares Developed Markets ex-US Quality Low Volatility Index Fund (QLVD) and the FlexShares Emerging Markets Quality Low Volatility Index Fund (QLVE) are passively managed and use a representative sampling strategy to track their underlying indexes. Use of a representative sampling strategy creates tracking risk where the Fund’s performance could vary substantially from the performance of the underlying indexes along with the risk of higher portfolio turnover. Although the funds seek lower volatility than their broader respective markets, there is no guarantee they will be successful as securities or other assets in the Fund’s portfolio may be subject to greater price volatility than the market as a whole. Foreign and emerging market securities involve certain risks such as currency volatility, political and social instability and reduced market liquidity. The Funds may also invest in derivative instruments. Changes in the value of the derivative may not correlate with the underlying asset, rate or index and the Funds could lose more than the principal amount invested. The Funds are also is at increased risk of Industry Concentration, where it may be more than 25% invested in the assets of a single industry.