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Alternative Tilting

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2:40 | Transcript

A market-weighted index is a common means of capturing total equity market exposure. Many investors believe that owning companies in proportion to their size in the market – as determined by the number of shares available to the public and the market price of the stock – creates the “optimal stock portfolio.”1

There can be a potential performance advantage to tilting a core equity portfolio to smaller cap and value stocks, as was demonstrated by the work of Eugene F. Fama and Kenneth R. French in the early 1990s.

But academic research and empirical evidence suggest that market weighting builds in a bias toward speculative growth and larger companies. Growth companies typically trade at higher multiples to their earnings or book value.2 The price for the firm’s stock is higher and so, in turn, is its market capitalization.

The investor who seeks total equity market exposure via a market-weighted index may pay more for each dollar of earnings or equity for growth companies. At the same time, they may not be fully compensated for the risks being taken by under-exposure to small cap and value stocks.

TILTING TOWARD SMALLER CAPS AND VALUE

There can be a potential performance advantage to tilting a core equity portfolio to smaller cap and value stocks, as was demonstrated by the work of Eugene F. Fama and Kenneth R. French in the early 1990s. Prior to Fama and French’s work, the general belief was that the expected future performance of a stock was tied directly to the volatility of the stock’s price versus that of the market. In other words, a stock whose price was more volatile (i.e., riskier) than the market – or had a beta greater than 1 – should earn more than the market return, to compensate the investor for taking on the additional risk.

Fama and French found that 90–95% of manager outperformance above beta was directly related to the size and value risk premiums.

But Fama and French found that beta did not fully explain the returns of a stock over time. Their research showed that two other factors played key roles in determining the expected future return of a company’s stock: the size of the company and its valuation. They found that the smaller a company’s market capitalization and the higher the ratio of the firm’s book value to its market value, the greater was its expected return. They also found that the return premiums provided by size and value factors were persistent over long periods of time. Why are size and value premiums available? There are two competing theories.

Those who believe that the market is efficient and that securities are always priced correctly think that any outperformance is likely due to the increased risk associated with smaller-capitalized companies and value firms.

  • Size risk premium: Firms that are less established (smaller) need to compensate investors by offering them greater returns for taking on excess risk (independent of price volatility).
  • Value risk premium: Firms in mature industries (value) need to compensate investors by offering them greater returns for taking on excess risk (independent of price volatility).

Those who believe that markets are inefficient think any outperformance is likely a function of the mispricing of these companies.

  • Size premium: Smaller companies are perceived as not providing investors with sufficient information (quality and quantity) to be accurately valued.
  • Value premium: What these companies are worth can often be underestimated because they are deemed to offer limited growth prospects.

THE REALITY BEHIND MANAGER SKILL
By applying regression analysis to historical returns, Fama and French found that 90–95% of manager performance was directly related to exposure to three factors: sensitivity to market volatility (market beta), exposure to the size risk premium and exposure to the value risk premium. The remainder was attributed to the manager’s skill in selecting stocks, known as alpha.3 Previously, under the Capital Asset Pricing Model (CAPM) one-factor model, active manager performance was viewed as coming from just two sources: the market beta of the portfolio (responsible for approximately 70% of expected returns) and alpha. Fama and French determined that many managers had “outperformed” their CAPM beta by simply adding exposure in their portfolios to small caps and value stocks.

MORNINGSTAR® U.S. MARKET FACTOR TILT INDEX

TOTAL U.S. MARKET INDEX COVERAGE  
Index % of U.S. Market
Morningstar® U.S. Market Factor TILT 99.5
Russell 3000 98
Dow Jones U.S. 95
S&P 500 85

Source: Northern Trust, January 2018. One cannot invest directly in an index.

Size

In order to effectively capture a more substantial size premium from the market, we believe an index needs to delve deeper into the investable universe than traditional broad market indexes. The Morningstar® U.S. Market Factor Tilt Index holds 99.5% of the investable U.S. equity universe. By going deeper than other market indexes, the Morningstar® Index seeks to capture more of the size premium while still avoiding the very bottom of the market that may have illiquidity issues.

FlexShares Morningstar® U.S. Market Factor Tilt Index Fund is engineered to provide deep exposure to the broad U.S. equity market, while seeking to take advantage of the persistent, longer-term small cap and value performance premiums.

Value

The Morningstar® Index also uses its proprietary value orientation score to classify securities that are undervalued and overvalued. This value orientation score is part of Morningstar’s style box framework for individual stocks, mutual funds and ETFs. The Morningstar® approach incorporates both forward-looking and historical factors into its classification methodology. The use of multiple value factors mitigates the risk of a stock being misclassified due to a company’s management decisions about financing options, cash flow usage, dividend policy or financial reporting.

FlexShares Morningstar® U.S. MARKET FACTOR TILT INDEX fund (TILT)
FlexShares Morningstar® U.S. Market Factor Tilt Index Fund is an exchange traded fund that is engineered to provide deep exposure to the broad U.S. equity market, while seeking to take advantage of the persistent, longer-term small cap and value performance premiums. To do this, the portfolio’s exposure to small cap and value stocks is re-engineered using a multi-factor modeling approach that attempts to enhance portfolio risk/return characteristics. The Fund may be a useful replacement for market-weighted core equity positions. It aims to provide investors with a total stock market option that we believe is more relevant to their longer-term capital appreciation needs.

 

1This is a key component of Harry Markowitz’s research on Modern Portfolio Theory.
2Book value is the sum of capital surplus, common stock and retained earnings.
3Alpha is a fund’s excess return relative to its benchmark.


IMPORTANT INFORMATION
FlexShares Morningstar® U.S. Market Factor Tilt Index Fund is subject to concentration risk. The Fund’s investments are concentrated in the securities of issuers in a particular market, industry, sector or asset class. The Fund may be subject to increased price volatility and may be more susceptible to adverse economic, market, political or regulatory occurrences affecting that market, industry, sector or asset class. The Fund 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 Fund could lose more than the principal amount invested.

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.