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UBS experts share their insights Selection criteria for ETFs
When selecting the right ETF (exchange traded fund), investors not only need to decide on an asset class and particular underlying; they should also, before investing, gain clarity on the following points:
Replication method
ETFs track, i.e. replicate, the performance of the underlying index. There are basically two types of replication method:
In physical replication, the ETF holds either all of the securities in the index in accordance with their weighting (full replication) or else a representative sampling (optimization procedure). The optimization procedure is used when the underlying index contains a very large number of securities or illiquid securities, and helps to reduce costs.
In synthetic replication, the ETF enters into an agreement, i.e. swap, with a counterparty (investment bank) that guarantees the performance of the underlying index to the ETF. This can be made either unilaterally or in exchange for the performance of a basket of securities and at the same time enables particularly accurate tracking of indices that are complex and difficult to access.
Tracking Error
The tracking error represents the volatility in the difference between the daily returns of each ETF and its respective underlying index.
Liquidity
Like stocks, ETFs can be traded on the stock exchange. The liquidity of an ETF is key for ensuring continuous tradability. Two levels of liquidity need to be distinguished: The first level has to do with the ETF and its on-exchange and OTC tradability. It is reflected in a low bid/ask spread (difference between buying and selling prices). The second level refers to the liquidity of the securities in the underlying index. As the ETF reflects the performance of the index and of the securities in it, their liquidity influences its own. As a general rule, standard indices like SMI or EURO STOXX 50 promise higher liquidity than do those with smaller values.
Handling risks
Although ETFs, as mutual funds, are not affected by any insolvency of the ETF provider, they are still exposed to certain specific risks. Physically replicated ETFs can engage in securities lending in order to reduce costs, with the risk that the counterparty may default on its obligation to return the borrowed securities. In synthetically replicated ETFs, there is the risk that the swap counterparty may not fulfill its obligation to deliver the performance of the underlying index. Transparent details on the collateral for these risks are published daily on the UBS ETF website. There are also other risks, such as market risks, sector risks, or currency risks.
Cost structure
Although ETFs are very inexpensive compared to other forms of investment, investors should find out about costs before buying. In the case of physically replicated UBS ETFs, the Management Fee or Flat Fee indicates the ongoing costs of the fund. The tracking difference indicates the deviation of the ETF’s performance from that of the underlying index.
