A Disciplined Duration Approach

THE CASE FOR MBS INVESTING A Disciplined Duration Approach MBSD INCOME RISK MANAGEMENT GENERATION The key concern with mortgage-backed securities (MBS) is the extension and contraction of effective duration. Since their introduction in 1970, residential mortgage-backed securities (MBS) have provided investors with quality fixed income returns. Whatever the economic or market environment, these securities historically have delivered a dependable, income-generating investment option. They typically offer such attractive investment characteristics as strong credit quality, attractive yields, diversification versus other fixed income sectors, frequent issuance and liquid trading markets. Like any investment segment, MBS possess certain shortcomings that must be managed as part of an investor s overall strategy. The key concern with MBS is the extension and contraction of effective duration. This requires constant monitoring and frequent adjustment by the MBS investor. In the time since Lehman s 2008 collapse, aggressive interventions by central banks drove global bond yields to sustained, record lows. By design, this has pushed investors on a search for yield in every investment asset class, sector and region. The search has stoked demand for MBS and reacquainted a broader swath of investors with legacy MBS products and their annoyances. Against this backdrop, and mindful of product innovations in the equity space, investors are ready for a new MBS product, one that captures attractive aspects of MBS while attempting to minimize the undesirable attributes. U.S. AGENCY FIXED-RATE MBS This sector ($4.7 trillion outstanding, as of 7/31/14 1 ), ranks among the largest, most liquid fixed income market segments. Agency MBS represent residential mortgage pools backed by the Government National Mortgage Association ( GNMA or Ginnie Mae ), the Federal Home Mortgage Association ( FNMA or Fannie Mae ), or the Federal Home Loan Mortgage Corporation ( FHLMC or Freddie Mac ). Known as the Agencies, they package individual mortgages purchased from mortgage originators and servicers into MBS that then are sold to investors. For a fee, the Agencies guarantee the timely payment of principal and interest on the mortgage pools. This guarantee gives the Agency MBS solid credit quality and proven market 1 Bloomberg, The BofA Merrill Lynch US Fixed Rate Mortgage Backed Securities Excluding Hybrid and IO Pools Index flexshares.com The Case for MBS Investing 1 of 6

Investors have had difficulty finding income-producing investments amid the global drop in sovereign and corporate bond yields. liquidity. The post-lehman regulatory overhaul remains unfinished and Congress is still debating how best to reform the U.S. government s role in mortgage securitizations. Reflecting the Agencies importance to the nation s housing sector, this debate has become so politicized that material changes to the rules are unlikely for the foreseeable future. The Agencies accounted for 98 percent of recent MBS issuance volume versus 45 percent (with 55% in privatelabel MBS) in 2005. 2 Private-label MBS do not carry Agency guarantees. Typically, mortgages in these pools comprise large jumbo loan sizes, high loan-to-value ratios, low borrower credit scores and/or high debt-to-income measures that don t meet Agency underwriting guidelines. Within the Agency MBS sector, to-be-announced ( TBA ) transactions give mortgage originators a standardized market in which to deliver mortgages (quickly returning capital back to the mortgage originations market) for eventual securitization and sale to investors. A TBA is a pass-through trade, an agreement to buy a soon-to-be-issued MBS that meets six parameters established at the trade s onset; these comprise issuer, maturity, coupon, price, par amount and settlement date. A constant supply of new TBAs, which carry the same collateral and credit backing as MBS, produces a very active trading market favored by investors. MBS YIELD AND DIVERSIFICATION ADVANTAGES Investors in recent years have had to scramble to find income-producing investments amid the global drop in sovereign and corporate bond yields. Generally, they have sought higher yields through legacy broad-market fixed income strategies with exposure across many fixed income sectors. However, while offering sector diversification, market-weighted fixed income products can be suboptimal for many investors. That s because they blindly mimic the shifting yield, duration, sector and credit-quality attributes of the broad market, driven either by changing rate/spread outlooks or by the maturation/issuance of index-eligible bonds. Table 1 below presents historical yield-to-worst 3 (YTW) and duration data from Barclays Capital Aggregate Bond Index (BC-AGG) and three of its subsectors (Agency Fixed-Rate MBS, U.S. Credit and U.S. Treasury). TABLE 1: BARCLAYS CAPITAL U.S. AGGREGATE INDEX DECEMBER 2003 TO DECEMBER 2013 YIELD-TO-WORST (%) DURATION (YRS) BC-AGG FIXED-RATE MBS U.S. CREDIT TREASURY BC-AGG FIXED-RATE MBS U.S. CREDIT TREASURY Average 3.84 4.32 4.63 2.75 4.7 3.6 6.2 5.3 Maximum 5.90 6.23 8.29 5.30 5.6 5.9 7.2 6.1 Minimum 1.56 1.64 2.46 0.75 3.5 0.7 5.5 4.8 Standard Deviation 4 1.28 1.21 1.25 1.39 0.4 0.9 0.4 0.2 Source: Barclays Capital Live 2 Federal Home Loan Mortgage Corporation, July 2014 Investor Update, Inside Mortgage Finance 3 Yield-to-Worst The lowest potential yield received on a bond without an issuer default 4 Standard Deviation A measure of the dispersion of a set of data from its mean flexshares.com The Case for MBS Investing 2 of 6

The duration of MBS generally moves up or down significantly more than that of other fixed income sectors. For the 10 years ended December 2013, data show that MBS provided higher yields versus Treasuries and comparable yields to U.S. Credit. The higher MBS yields were achieved despite a lower average duration. Compared with U.S. Credit, MBS generated similar average yields with 2.6 years less average duration. MBS also posted the lowest volatility of YTW in the group. Throughout the period, MBS offered higher yields with similar credit quality to Treasuries and, compared to U.S. Credit, superior asset quality with similar yields. Viewed over time, most MBS metrics profile favorably to other fixed income sectors. But one metric does not. When market events change the consensus outlook for interest rates and impact the expected levels of MBS principal repayments, the duration of MBS generally moves up or down by significantly more than the duration of other fixed income sectors. This extension/contraction risk is reflective of the higher-duration standard deviation of individual MBS. In recent years, new regulations have caused trading liquidity in the bond markets to deteriorate. Certain regulations introduced onerous capital requirements that restricted the investment banks use of their balance sheets to support a traditional fixed income underwriting/trading model. As result, investors find it more challenging to conduct timely and efficient buy/sell programs (especially across multiple fixed income sectors). Not surprisingly, the diminished trading dynamic has triggered much brainstorming about new fixed income products that would work better with today s investing and market-making realities. MBS DURATION - EXTENSION/CONTRACTION RISK Changes in the effective duration 5 for MBS primarily reflect shifts in prepayment estimates on the underlying mortgages. Driving such prepayment changes are swings in interest-rate levels, mortgage credit availability, household formation, housing prices and housing turnover. Traditionally, investors access the MBS market using products that track various legacy, marketweighted, sector-mbs indexes. Graph 1 below presents the historical effective duration over the past 15 years for the Barclays U.S. Agency MBS Index, along with durations from Barclays Asset-Backed Securities ( ABS ), Commercial MBS ( CMBS ) and U.S. Credit sector indexes, all of which are included in the BC-AGG. GRAPH 1: BARCLAYS CAPITAL AGGREGATE SECTOR DURATION JUNE 1999 TO APRIL 2014 8 6 4 2 0 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 ABS CMBS U.S. Credit Agency Fixed-Rate MBS MBS Average Source: Barclays Capital Live as of April 30, 2014 5 Effective Duration Calculation that accounts for why expected cash flows fluctuate with changes in interest rates for bonds with embedded options flexshares.com The Case for MBS Investing 3 of 6

FlexShares MBS strategy seeks to reduce the volatility of effective duration and improve the variability of monthly returns while also enhancing trading liquidity. The market-weighted Barclays MBS sector index comprises Agency fixed-rate MBS and has possessed an average effective duration of 3.4 years over the subject time period. The MBS sector index has experienced higher overall volatility compared to the other fixed income sector components comprising the BC-AGG. Significant market events will whipsaw the effective duration of any sector MBS index. The May/June 2013 Taper Tantrum, the late 2003-04 change in Federal Reserve monetary policy and Lehman s bankruptcy in 2008 serve as prime examples of this phenomenon. Extending or contracting MBS effective durations creates unanticipated interest-rate risks, leading to unexpected portfolio outcomes. Typically, these require an investor to initiate corrective or offsetting actions. DISCIPLINED DURATION MBS INVESTING Previously, FlexShares addressed the risks of duration volatility with its target-duration U.S. TIPS products. Building on this foundation, FlexShares MBS strategy seeks to reduce the volatility of effective duration and improve the variability of monthly returns while also enhancing trading liquidity. Additionally, placing the strategy within an ETF structure provides an accessible, daily traded and efficient investment product for taking MBS exposure within a portfolio. FlexShares collaborated with BofA Merrill Lynch Bond Index Research Group to design a passive, rules-based, fixed-rate Agency MBS index that strives to address these objectives. To provide clients with a more efficient strategy for managing MBS duration/interest-rate risk, FlexShares sought to deliver a strategy with monthly variability of an MBS index s effective duration within a one-year band. Based on historical data and FlexShares analysis, an effective duration midpoint of 3.75 years was established, with a plus/minus band of 0.5 years (3.25 4.25 year effective duration band). This strategy analyzed such factors as: Federal Reserve policy actions and their impacts on the long-term composition of mortgages outstanding Outlooks for U.S. interest rates Potential reforms of agency mortgage programs Credit availability Potential for increased Agency mortgage-guarantee fees Structural changes in U.S. home ownership, along with other factors The Federal Reserve s bold monetary interventions throughout the post-financial crisis period have increased the volume and concentration of low-coupon MBS. This also has broadened the mix of outstanding MBS coupons (known as the Coupon Stack ). Given that the Federal Reserve is expected to end its bond-buying program in October 2014 (and most investors anticipate that market interest rates will rise eventually), the underlying mortgages held in low-coupon MBS pools have a reduced likelihood of being refinanced (resulting in longer effective durations for MBS). FlexShares believes tighter underwriting standards, higher required down payments, increased mortgage-guarantee fees and lower homeownership trends in the U.S., specifically among those in their 20s and 30s, will likewise cause effective durations on MBS to lengthen. INDEX ANALYSIS AND DEVELOPMENT The investible universe of MBS drew from The BofA Merrill Lynch US Fixed Rate Mortgage Backed Securities Excluding Hybrid and IO Pools Index ( M0AN ), a legacy, market-weighted index of Agency fixed-rate mortgage pools. FlexShares initial disciplined duration methodology was applied to the eligible universe and tested over a 10-year period that ended Dec. 31, 2013. flexshares.com The Case for MBS Investing 4 of 6

FlexShares Disciplined Duration MBS Index Fund unites market liquidity and duration management for an improved MBS investing experience. Mortgage pool eligibility and concentration tests were included in the methodology to enhance liquidity of the underlying holdings. Testing found that the monthly variability of effective duration within mortgages was so great that to stay strictly within a set duration band around a targeted duration midpoint, the band needed to be set wider than one year. At such an extreme level, the band would conflict with the investment objective of reducing effective duration variability. In place of strict duration band enforcement, the analysis moved to using the duration bands as guideposts for the monthly rebalancing methodology. After much testing and refinement, the index construction efforts produced The BofA Merrill Lynch Constrained Duration U.S. MBS Index (the Index ). The Index indicates that FlexShares disciplined-duration MBS methodology potentially can give investors the opportunity to achieve: Investment objectives of reduced MBS effective duration variability Equal or improved investment returns Less turnover Enhanced liquidity versus a market-weighted MBS index This can all occur while maintaining the yield and income benefits of MBS. Armed with this investment strategy, investors can position MBS exposure more efficiently and effectively within their overall portfolios. IMPACT OF REGULATORY CHANGES ON MORTGAGE TBA PARTICIPATION Fallout from the financial crisis undermined Fannie Mae and Freddie Mac. As a result, their regulator, the Federal Housing Finance Agency, placed both into conservatorship. Following the crisis, Congress and President Obama called for stricter regulatory oversight and new rules for the mortgage securitization industry. At this point, many of the proposed reforms have endured a recurring cycle of study, debate and delay. However, effective in 2014, the Treasury Markets Practices Group ( TMPG ) approved one change. It mandated that forward-settling mortgage trades, including TBAs, be subject to margining to reduce counterparty risk. Practically, this requires that MBS investors execute direct Master Securities Forward Transaction Agreements ( MSFTA ) with all counterparties. Reflecting the economics and logistics of employing MSFTAs, many MBS investors, both retail and institutional, decided to stop TBA trading. These investors likely are searching for other ways to gain exposure to MBS through an alternative to TBAs. ETF LIQUIDITY The structure of ETFs, with timely and economical intraday trading, addresses key challenges facing the fixed income and MBS markets. The ETF structure moves fixed income trading from traditional low transparency, over-the-counter platforms and onto exchanges where market makers stand ready to buy and sell ETF shares. An investor now can gain exposure to a diverse basket of hundreds of MBS via one ETF ticker and transaction. For those accustomed to investing in TBAs, whose access is blocked by problematic new regulations, FlexShares Disciplined Duration MBS Index Fund provides an effective TBA substitute that unites market liquidity and duration management for an improved MBS investing experience. FOR MORE INFORMATION Consult with your financial professional concerning how FlexShares Disciplined Duration MBS Index Fund (MBSD) can help you pursue your investment objectives. Or, contact FlexShares at 1-855-FlexETF (1-855-353-9383). flexshares.com The Case for MBS Investing 5 of 6

IMPORTANT INFORMATION Before investing, carefully consider the FlexShares investment objectives, risks, charges and expenses. This and other information is in the prospectus, a copy of which may be obtained by visiting www.flexshares.com. Read the prospectus carefully before you invest. Foreside Fund Services, LLC, distributor. An investment in FlexShares is subject to numerous risks, including possible loss of principal. Fund returns may not match the return of the respective indexes. The Fund is subject to the following principal risks: asset class; concentration; counterparty; derivatives; fluctuation of yield; geographic; income; interest rate /maturity; issuer; management; market; market trading; new funds; passive investment; and tracking error risk. A full description of risks is in the prospectus. In addition, FlexShares Disciplined Duration MBS Index Fund is subject to credit risk, which is the risk that the inability or unwillingness of an issuer or guarantor of a fixed income security, or a counterparty to a TBA, repurchase or other transaction, to meet its payment or other financial obligations will adversely affect the value of the Fund s investments and its returns. Changes in the credit rating of a debt security held by the Fund could have a similar effect. Debt extension risk is the risk that an issuer will exercise its right to pay principal on an obligation held by the Fund (such as a mortgage-backed security) later than expected. This may happen during a period of rising interest rates. Under these circumstances, the value of the obligation will decrease and the Fund will suffer from the inability to invest in higher-yielding securities. Mortgage-backed pass-through securities risk is the risk of investing in mortgage-backed securities issued by a U.S. Agency. These securities may not be backed by the full faith and credit of the U.S. government. As interest rates rise, bond prices fall, reducing the value of fixed income investments. MBSD employs a representative sampling strategy. Its performance may vary substantially from the performance of the Underlying Index and may incur tracking error to a greater extent than a fund that seeks to replicate an index. Merrill Lynch, Pierce, Fenner & Smith Incorporated and its affiliates ( BofA Merrill Lynch ) indices and related information, the name BofA Merrill Lynch, and related trademarks, are intellectual property licensed from BofA Merrill Lynch, and may not be copied, used, or distributed without BofA Merrill Lynch s prior written approval. The licensee s products have not been passed on as to their legality or suitability, and are not regulated, issued, endorsed, sold, guaranteed, or promoted by BofA Merrill Lynch. BOFA MERRILL LYNCH MAKES NO WARRANTIES AND BEARS NO LIABILITY WITH RESPECT TO THE INDICES, ANY RELATED INFORMATION, ITS TRADEMARKS, OR THE PRODUCT(S) (INCLUDING WITHOUT LIMITATION, THEIR QUALITY, ACCURACY, SUITABILITY AND/OR COMPLETENESS). flexshares.com The Case for MBS Investing 6 of 6 Q56263 (12/14)