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FlexShares Plans to Foray into MBS ETF Space

Zacks Equity Research

FlexShares, the issuer which has so far provided only three products in the fixed-income space, appears to be broadening its exposure. Recently, the issuer filed for a new passively managed product in the fixed-income space, though in the form of mortgage-backed pass-through securities.

While the initial filing was less informative providing no information on key considerations like expense ratio, the methodology that the issuer looks to apply was described in detail. Below, we have emphasized some of these key details on this in-registration product:

Proposed Methodology

The proposed ETF looks to track the Disciplined Duration MBS Index which replicates the performance of a selection of investment-grade US agency mortgage-backed pass-through securities (MBS.V).  

A mortgage-backed security is created by a process known as securitization. It is a process by which illiquid loans are transformed into tradable securities. In case of MBS, the underlying loan is a mortgage loan. Most MBS are “pass through securities” guaranteed by Govt. Sponsored Enterprises (GSEs). These include Ginnie Mae, Freddie Mac and Fannie Mae (read: Guide To MBS ETF Investing).

Investors should also note that weighting in the index will be market cap-based and effective duration-based. The index takes into account various fixed-rate mortgage-backed securities.  The Index first groups the MBS pools into generic aggregates screening those on criteria like agency, mortgage program, pass-through coupon and origination year.

Once this has been accomplished, MBS with a weighted-average remaining maturity of at least one year is chosen for inclusion in the underlying index, having been issued by a US Agency, possessing a minimum of $1 billion of outstanding face value and are characterized by one or more of the fixed-rate mortgage programs with 30-year, 20-year, and 15-year maturities.

How does it fit in a portfolio?
This proposed product could be an interesting choice for investors seeking exposure to the mortgage backed securities ETFs. The space stands out as a stable performer this year thanks to the plunge in rates. Interest rates in the U.S. are not going up as earlier feared by the market, goading the appeal for all sorts of bond investing including MBS (read: 3 Long Term Bond ETFs Surging as Rates Stay Low).
Investors should note that MBS normally yields higher than the Treasury bond with similar credit rating. Thus, investors looking for higher income in this environment might find mortgage-backed securities an enticing option. Low rates bolstered the prices of MBS fixed-rate bond ETFs, of late. This year, the large MBS ETFs have returned more than 3%. 

However, the MBS space is not at a great shape at present. Freddie Mac pointed out that mortgaged homeowners bought their homes at rock-bottom rates or refinanced into a low-rate mortgage (read: Time to Worry about Homebuilder ETFs?).

Freddie Mac also said that the Bureau of Economic Analysis approximated that the average interest rate on single-family mortgages outstanding was 3.9% during Q1 of this year, much lower the average 30-year fixed-rate of 4.4% for new loans during the same quarter. However, though mortgage volume is currently subdued in the market, the activity should pick up in the coming quarters as the economy perks up.  

ETF Competition

The space is still not teeming as only a handful of products are presently playing. Among these, iShares Barclays MBS Fixed-Rate Bond Fund (MBB) tops the list with about $5.7 billion in assets. The next winner by AUM – Vanguard Mortgage-Backed Securities ETF (VMBS) – stays at a distance with about $419 million in AUM. Both of these products have low concentration risks.

This suggests that MBB has almost monopolized the MBS ETF space. The trend could change if FlexShares successfully brings its new product to market, though investors will have to wait and see if the proposed fund, if ever approved, can buck the trend and accumulate a decent amount of assets in this often overlooked corner of the market.

Also, the average expense ratio charged by the space is 27 bps with the topper MBB charging 31 bps in fees while the runner-up VMBS being the most cost-effective option. Thus, to attract investor attention, the proposed fund needs to be priced competitively, preferably lower than the average expense ratio.

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