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On Track Research
July 2018: The merits of multi-factor investing
Multi-factor exposures tend to deliver return enhancement, whilst limiting the drawdowns and inherent cyclicality associated with single factors. Indexed multi-factor portfolios have successfully delivered excess returns vis-à-vis market cap-weighted portfolios over the long term (historical back-tests), as well as the more recent live track period.
Previous ETF Market Matters publications - 2017
August 2017: Indexing 360°: Multi-Factor Investing
With the growing popularity of smart-beta investing and the many new solutions available on the market, potential buyers are considering ways to add these to their portfolios. One approach is to invest in single factors such as value, quality, dividend, low volatility etc., all of which are now available via passive vehicles including ETFs.
July 2017: Indexing 360°: Choosing the right alternative beta index
The choice for an investor in the passive space is two dimensional. First, an investor has to decide on the right benchmark from a wide array of opportunities, which include market cap-weighted, sector, smart-beta, SRI, theme and other indices, not to mention those with embedded currency hedged overlays. These provide good flexibility as building blocks for passive as well as active portfolio management.
June 2017: Indexing 360°: MSCI EMU vs EURO STOXX 50
Passive investing has developed as a convenient, liquid, and cost-efficient way to invest in flagship indices covering broad markets (e.g., S&P500) and blue chip stocks (e.g., Dow Jones 30). They constitute the core of passive portfolios and provide investors with the equity risk premium for bearing (undiversifiable) market risk. Investors have ample access to these exposures via ETFs, index funds, mandates, and other passive vehicles.
April 2017: Inflation protection in a rising rate environment
Treasury inflation-protected securities (TIPS) are treasury bonds that have their notional value adjusted in line with realized inflation. They are therefore a convenient solution for investors seeking to preserve real purchasing power. Currently, 10-year TIPS are priced such that they will outperform nominal Treasuries if the realized inflation over the next 10 years exceeds on average 2.0% per annum.
January 2017: Lower for Longer: What if inflation bounces higher?
Over the past years a number of economic events including, amongst others, the Financial Crisis of 2007–2008, the European Sovereign Debt Crisis of 2011–2012, through to the recent Oil Price Drop in 2015, have led inflation expectations to low levels. Despite massive monetary stimuli, inflation figures have generally remained low with little indication of rising attempts.
Previous ETF Market Matters publications – 2016
The current fixed income environment is challenging. Yields on core fixed income benchmarks are near historical lows, yet interest rate risk has increased. For example, the Barclays Global Aggregate bond portfolio has seen its yield decline from around 9% at the beginning of the 1990s to just above 1% currently.
The premise of factor investing, also known as smart beta or alternative beta ETFs, is that stocks with certain characteristics known as ‘factors’ outperform the market in the long term. The most common factors include Value, Size, Momentum, Dividend Yield, Quality and Low Volatility. Factor ETFs have lately experienced a growth in investors’ interest with the five-year cumulative annual growth rate in invested assets of more than 30%.
For decades, the investment paradigm for many investors centered on constructing core equity-bond portfolios to meet return objectives. In the past, the equity component would regularly have provided healthy returns (often double digit), while bonds were expected to provide diversification benefits and thus reduce portfolio downside risk in times of distress. Given that there is limited room (if any?) for further interest rate reductions, investors face a very challenging environment in the fixed income space. This has forced investors to search for yield beyond advanced economies and high quality credit.
The past two decades have witnessed an extraordinary decline in interest rates across major advanced economies. More recently, the financial crisis and the European sovereign crisis have prompted central banks to undertake far reaching quantitative easing (QE) policies that have brought down yields to new historical lows. In the “lower for longer” scenario, investors are likely to benefit from a multi-asset allocation approach while searching for yield beyond traditional benchmarks. We show that alternatives and smart beta strategies could add value.
Previous ETF Market Matters publications – 2015
CHF bonds and passive opportunities
The Swiss Confederation has substantially reduced the issuance of new debt in recent months with volumes turning net negative, for the first time since 2012. It will be also conservative when issuing in the second half of 2015. For investors seeking CHF-denominated fixed income investments this move implies they should consider bonds from other issuers (domestic or foreign), or papers listed in the secondary market. While volumes of domestic non-government issuers have soared, foreign issuers have repaid more than they have issued, reducing their total outstanding CHF-denominated debt.
In light of this scenario, two options based on indexed- investments are discussed: Mortgage Bond Institutions (performance captured by the SBI® Domestic Swiss Pfandbrief Index) and Investment Grade Foreign Issuers (SBI® Foreign AAA-BBB Index). Both investments offer a modest yield pick-up over government bonds and both have outperformed the risk free benchmark (SBI® Domestic Government) in recent years.
Equity Benchmarks, Half-Year Review
During 1H-2015, global equity markets experienced mixed performance due to a variety of factors. Local markets responded differently to monetary policies and economic growth prospects. This review looks into the equity benchmarks as of 30 June 2015 (excluding the China turmoil of the few last days). The focus is on one family of indices. The analysis is carried out for one currency, the US dollar, and covers developed as well as emerging markets. In addition, particular attention is placed on Eurozone equities.
- The year-to-date performance is related to long-term return, which allows one to spot some outliers and inliers. Similarly, the study looks into basic valuation ratios.
- Overall, developed equities have performed better than emerging equities (with some exceptions like China or Russia).
- Within Eurozone equities, we look into several indices covering style investing, sector exposure and small-caps.
Grexit (lessons from past stress events)
Should the Greek government fail to reach an agreement with its creditors and international partners during the meetings scheduled for the coming days, a further intensification in the crisis seems likely. The economic exposure to Greece amongst Eurozone corporates appears very modest. This suggests limited impact (in the long-run) for the ongoing Eurozone recovery, should a Grexit turn as the outcome. This, however, does not rule out potential of a short-term shock.
- We study behaviour of key equity, government and currency benchmarks in view of past stress events. A cross-asset study looks into what one may expect under different stress scenarios.
- Europe-concentrated equity exposure implies a weak hedge for Grexit-associated tail risk. Gold (and CHF), as well as short-duration risk free fixed income appear to perform well shortly following stress events, and de-correlate from equity
EUR and USD Credit Spreads: Aggregate vs. Investible Exposures
The divergence in EUR and USD credit spreads has been one of the key topics in bond markets over recent weeks. Figure 1 shows the credit spreads (incremental yields over the benchmark risk free government issues) for EUR- and USD-denominated investment grade (IG) aggregate corporate exposures, highlighting indeed a recent period of divergence. In this study:
- We compare investment grade corporate aggregates and see that USD spreads have been widening since July '14 and drifting away from EUR spreads, which levelled off. We point out common arguments behind divergence.
- We attribute spreads to sectors and maturities. Furthermore, we investigate two investible corporate exposures, rather than the aggregates, and demonstrate that liquidity clearly matters.
- As default risk only accounts for part of the credit spread, the non-default component is strongly related to bond liquidity. Investors looking for credit risk premium only should focus on liquid indices that 'remove' the liquidity premium. We discuss two options based on Barclays Liquid Corporate Indices.
Eurozone Small Caps
This study follows on from previous Market Matters, looking into Eurozone equities. Particular attention is given to small caps:
- Global small cap investors were historically compensated excess risk-adjusted return of 0.22% p.a., the so-called "small-cap premium".
- Eurozone small caps historically delivered the highest risk-adjusted return, in relation to standard exposure.
- Within Eurozone equity indices, the MSCI EMU Small Cap Index currently features the highest earnings growth.
- The more cyclical nature of small caps benefits from an ongoing improvement in the economic environment in the Eurozone.
Eurozone Equities: Index Strategies Revisited
Equities with the European exposure have attracted most of the inflows into the European-domiciled Exchange Traded Funds (ETFs) in January 2015 (Source: ETFGI monthly report), making up nearly USD 7bn out of 9bn in overall inflows. Following on from these flows, this study looks into Eurozone equities from a exposure perspective representing a suite of investible strategies. Specifically, we compare standard Eurozone exposure (EMU Index which captures large- and mid-caps weighted according to market capitalisation and which reflects the market portfolio) against alternative exposures:
- large cap and small cap
- value stocks and growth stocks
- cyclical sectors and defensive sectors
The major findings can be summarized as follows:
- Empirical findings indicate a consistent size premium, fading value premium (with a sign of rebound) and a need for sector rotation.
- For foreign investors with non-EUR funding currency, currency hedging proves critical in periods of high volatility in exchanges rates.
ECB's QE- any yield left?
On January 22nd, the Governing Council of the European Central Bank's (ECB) presented the details of the expanded asset purchase programme (Quantitative Easing, QE). The ECB will buy government bonds (on the yield curve, up to 30 years) in the secondary market, and the purchases of securities will be based on the National Central Banks’ shares in the ECB’s capital key. The prospective implication is that investors will likely get "crowded out" from the sovereign market, leading to a continued appetite for corporate credit.
This market matters presents the current yield landscape based on EUR-denominated fixed income benchmarks, and focuses on the investment-grade credit segments:
- The only "yielding papers" of the Eurozone sovereign issuers are long-term (10+ or so).
- The incremental yield can be 'sourced from' EUR corporate bonds, in particular if an issuer is a non-Eurozone corporate.
Previous ETF Market Matters publications – 2014
Dividend-focused strategies attempt to buy high-quality dividend-paying companies at competitive prices. Such a strategy can be also indexed, i.e. placed into rules-based framework which creates an investible index holding the best stocks in view of pre-defined, dividend-focused eligibility criteria.
Such a dividend strategy weights selected stocks according to their dividend yields, i.e. higher yielders receive a higher allocation, with the intention of harvesting dividends. For example, the Dow Jones Global Select Dividend index measures price and yield performance of 100 leading dividend-paying companies worldwide. This strategy delivers a two-fold higher yield than the aggregate as shown in Figure 1.
Figure 1: Dow Jones Global Select Dividend: dividend yield vs. aggregate (in %)
Eurozone economic growth and the recovery in earnings remain modest. Given that investors have formulated different views and forecasts on this recovery, it is worth considering a sector allocation approach, in view of its sensitivity to the economic cycles.
This study discusses the features of the MSCI Cyclical and Defensive Sectors Indices, covering Eurozone exposure. A key focus are capped indices with an equal allocation to sectors - within cyclical or defensive exposure – ruling out over-concentration. The historical performance shown on Figure 1, highlights mean-reversion feature of the 'spread' between cyclical and defensive sectors, providing investors with an option to rotate between exposures.
Figure 1: Relative performance: MSCI EMU Defensive vs. MSCI EMU Cyclical
While standard market capitalisation-weighted indices represent the market return, some of you may seek exposure to global equities at lower risk (or volatility) compared to the standard benchmark. This newsletter discusses the features of a few risk-adapted strategies offered through MSCI investible indices, ranging from tilting towards low volatility stocks (Risk Weighted), minimizing total risk (Minimum Volatility) and targeting total risk (Risk Control). These strategies provide access to broad equity with a lower long-term risk than the standard cap-weighted benchmark. The Risk Weighted index-based strategy performed best over analysed period, whilst the Minimum Volatility index-based strategy featured the lowest realized risk.
On Thursday September 4th, the ECB surprised global investors by announcing another set of monetary policy easing measures aimed at staving off EMU deflationary trends and at stimulating economic recovery. Global investors also await the results of the Scottish independence vote of September 18th, the outcome of which may have financial implications on international markets. These two events have ignited currency volatility as seen in the chart below.
For investors interested in pure international equity exposure, increased currency volatility implies (undesired) volatility noise, as it provides no explicit return, such as dividend, earnings growth or capital appreciation. Currency movements can be dynamic and investors need to develop their own currency risk management policy and tools to suit their investment objectives. This report presents a possible solution to constructing a global equity exposure achievable by aggregating regional currency hedged ETF building blocks.
In addition to conventional financial criteria, Socially Responsible Investing (SRI) takes into account social aspects of an investment. Given that corporate and social responsibility can potentially impact profitability and the cost structure of companies, it is worth comparing fundamental data and the risk-adjusted performance of SRI portfolios vs. their respective benchmarks. This brief study focuses on the investible SRI indices within the MSCI family, and concludes:
- MSCI's major SRI indices have outperformed their conventional parent indices in risk-adjusted terms
- MSCI SRI portfolios generally have higher price-to-book value ratios, similar dividend yields, and lower trailing earnings, when compared to their respective parent indices.
- Additional investment returns, on top of that delivered by conventional portfolios, shows investors are willing to pay a premium for a positive social tilt achieved with the SRI approach.
For some investors, growth stocks appeal to their desire for high earnings potential, while value stocks featuring above-average dividend yields and low price-to-book ratios typically attract those hunting for a bargain. This report examines these two equity styles from an investible index viewpoint, and concludes:
- As a result of above-average dividend income, value stocks have delivered superior total return over standard portfolio and growth stocks (both in USA and EMU) in recent years.
- Given similar earnings levels, the dividend yield differential proves to be a key factor for a superior total return of the USA Value index over its USA Growth counterpart.
- Assuming a Eurozone recovery, current low earning levels may give a base effect for earnings growth that will favour the EMU Growth index over the EMU Value index.
On the 5th of June, the ECB announced a monetary policy action to provide further stimulus for the Eurozone economy and to mitigate the material risk of deflation. The key measures include a negative deposit rate and a package of up to €400bn of cheap funding for Eurozone banks in an attempt to boost lending on the condition that it will be lent non-financial sector companies (and not for mortgages). This report looks into the EMU equities and fixed income performance, as compared to other benchmarks and in the context of the announced policy action. EMU equities appear to be catching up with global benchmarks after the underperformance experienced in 2011-2012. Sovereign bond yields show substantial differentiation across EMU members, but the premium demanded by investors to compensate them for the credit risk of investing in Spanish or Italian debt is reverting back to the levels of the German or French issues.