Under The Hood: Tilting Toward Emerging Markets

There is no shortage of emerging markets ETFs on the market today. In particular, investors have a plethora of funds offering exposure to multiple countries from which to choose. That does not stop ETF issuers from bringing more of these funds to market.

Take the example of the FlexShares Morningstar Emerging Market Factor Tilt Index ETF (NYSE:TLTE), which debuted just last week. FlexShares, a unit of custodial bank Northern Trust (NASDAQ:NTRS), is a new entrant to the ETF game. The firm unveiled four ETFs just over a year ago, including the FlexShares Morningstar Global Upstream Natural Resources Index ETF (NYSE:GUNR).

Unbeknownst to many investors, the FlexShares suite, GUNR included, has proven quite successful as the firm's first four funds have over $1.6 billion in assets under management combined.

Do not rule out the FlexShares Morningstar Emerging Market Factor Tilt Index ETF as a contender to rapidly gain assets. FlexShares ETFs have entered crowded arenas before only to flourish with GUNR standing as a prime example.

The FlexShares Morningstar Emerging Market Factor Tilt Index ETF is pricy compared to other well-known multi-country emerging markets ETFs. TLTE charges 0.65 percent per year, well above the fees found on the Vanguard MSCI Emerging Markets ETF (NYSE:VWO).

TLTE does have its high points. The new ETF offers exposure to all cap spectrums, meaning large-caps represent just 47.6 percent of the fund's weight. Even micro-caps land an allocation of 3.2 percent. TLTE "applies a tilt to small-cap and value stocks using a multi-factor modeling modeling approach that attempts to enhance portfolio risk/return characteristics," according to the fund's fact sheet.

At the sector level, financials rule the roost with an allocation of 22.2 percent. Technology, materials, consumer discretionary and energy names all receive double-digit weights with industrials barely missing out on a 10 percent allocation.

The biggest flaw with TLTE is not its expense ratio nor is it the heavy weight to financials. Regarding the latter factor, it is something investors familiar with emerging markets ETFs have to come to expect as it is often bank stocks that are among the largest names in an array of developing nations.

Rather, the potential black mark against TLTE is that the fund makes a mistake that so many other ETF sponsors have made with multi-country emerging markets funds. That is granting large weights to South Korea and Taiwan. The two countries combine for over 29 percent of TLTE's weight even though their status as developing nations is dubious at best.

ETFs tracking indexes created by MSCI, which continues to classify South Korea and Taiwan as emerging markets while other marquee index providers do not, have an excuse, but TLTE does not track an index constructed by MSCI. Throw in a 9.2 percent weight to Hong Kong, also not a developing nation, and TLTE becomes a good option for a more conservative investor looking for international exposure.

TLTE features minimal exposure to Asian growth markets such as Indonesia and Malaysia and its Latn America exposure seems to consist of a combined 17 percent weight to Brazil and Mexico. Unidentified countries make up 11.8 percent of TLTE's weight, but without knowing if "other" consists of Chile, Colombia, the Philippines and Thailand (markets that plenty of investors want exposure to), it is hard to praise TLTE's country lineup.

This is not to say TLTE is a bad ETF. It is too young to say that if anything, the methodology behind the fund combined with small-cap and value tilt could prove to be efficacious.

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