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How can you minimize securities lending risk for ETFs?
Which replication methods are used for UBS ETFs?
Generally, there are two types of ETFs: physically replicated ETFs and synthetically replicated ETFs. For physically replicated ETFs, a distinction is made between full replication and optimized replication using a mathematical optimization procedure (stratified sampling).
In full replication, the ETF is in physical possession of all of the securities represented in the benchmark, in accordance with their weightings. Index adjustments and capital measures make regularly scheduled transactions necessary.
In optimized replication with stratified sampling, the ETF physically holds a subset of index constituents. The performance of the basket of securities is based on the physical holdings in the ETF. Optimization strategies and tools are applied to reduce transaction costs, increase liquidity and minimize tracking error. UBS Portfolio Management in London uses sophisticated analytical tools to define a subset of the index constituents which will provide a return similar to the original stocks in the index. The maximum spread according to the sales prospectus is 5%. Currently, stratified sampling is being used for only three ETFs.
In the case of synthetically replicated ETFs, the fund does not actually hold the underlying securities of the index but instead relies on swaps to deliver the performance of the index. There are unfunded swaps (total return swaps) and fully funded swaps.
How does unfunded swap-based replication work (total-return swap)?
The ETF holds a basket of securities agreed between the portfolio manager and swap counterparty; the final decision rests with the portfolio manager. The basket may contain only part of the index constituents, or even include securities not related to the underlying index.
The performance of the basket is exchanged against the performance of the underlying index. The swap counterparty guarantees the total return performance, less fees and expenses, of the fund (constant performance drag), which leads to zero tracking error. The swap counterparty generates the index performance by investing in securities or derivatives which track the index performance. Counterparty risk in the fund is limited to 10%, in line with UCITS IV.
How does fully funded swap-based replication work?
The ETF pays the cash inflow from the client to the swap counterparty. Counterparty risk is mitigated through 105% collateralization using only G10 bonds. The fund holds only one fully funded swap, which delivers the performance of the underlying index. The swap counterparty guarantees the total return performance, less fees and expenses, of the fund (constant performance drag), which leads to zero tracking error.
The swap counterparty generates the index performance by investing in securities or derivatives which track the index performance.
Who are the swap counterparties for UBS?
For all UBS ETFs, UBS Investment Bank is the exclusive counterparty for all OTC swap transactions. UBS credit ratings are Standard & Poor’s: A (November 29, 2011) and Moody's: A2 (June 21, 2012) (as of August 2013).
Is swap exposure collateralized? What are the minimum collateral quality standards?
Counterparty risk associated with OTC derivatives is mitigated through collateralization of the exposure under the relevant swap agreement. Solely G10 government bonds are accepted. Collateral is held in a segregated account in the name of the fund (transfer of ownership model).
Who is custodian of swap collateral?
State Street acts as custodian bank for swap collateral of all swap-based UBS ETFs except for the UBS ETF (CH) CMCI Oil. Swap collateral for this fund is held in custody by UBS AG.
How often is the level of collateral for each swap monitored and marked-to-market?
What is the minimum swap collateralization level, and how is it enforced?
The minimum level for fully funded swaps is 105%. Under UCITS regulations, a fund may not have a counterparty exposure greater than 10%.
What happens if the swap counterparty (UBS Investment Bank London) defaults?
Because, in the fully funded swap structure, the collateral is owned by the fund (and is not pledged), the collateral reverts to the fund. A new swap counterparty would then be appointed by UBS Asset Management.
Why are most swap-based UBS ETFs domiciled in Ireland?
UBS has a management company domiciled in Ireland, which has a proven track record in managing swap-based structures.
What is securities lending?
In securities lending the lender (UBS ETFs) transfers a certain number of securities from the ETF portfolio to a third party (borrower) for an agreed term.
Do UBS ETFs participate in securities lending?
Yes, some UBS physically replicated ETFs domiciled in Luxembourg, Ireland and Switzerland participate in securities lending. However, for precious metal UBS ETFs the fund management company does not carry out any precious metal lending transactions.
Why do UBS ETFs participate in securities lending?
Securities lending by the fund generates additional revenues (typically 1-20 bp, depending on the index). Securities-lending revenues are reflected in the NAV, directly reducing the net cost to investors.
Who is the securities lending agent for UBS ETFs?
The securities lending agent for Luxembourg-domiciled ETFs is State Street Bank GmbH, London Branch, and State Street Bank and Trust. For Swiss UBS ETFs, UBS AG acts as both lending agent and borrower.
Who are the securities lending borrowing counterparties for Luxembourg-domiciled UBS ETFs?
State Street acts as lending agent. The borrower list of the lending agent is approved by UBS representatives. In addition, it matches with the UBS counterparty list. The counterparty risk is monitored on a daily basis by the lending agent, State Street. State Street also provides default indemnification in the event that a borrower is unable to return securities. Securities lending transactions of UBS ETFs are fully collateralized.
Who are the securities lending borrowing counterparties for Swiss-domiciled UBS ETFs?
UBS AG is the sole borrower (principal) in respect of the ETF and guarantees all contractual duties and protects the ETF from any hypothetical default of UBS AG's borrowers. To protect the ETF against UBS counterparty risk, UBS AG provides collateral according to stringent FINMA regulations (Collective Investment Schemes Ordinance).
What is the general process for Luxembourg UBS ETFs securities lending?
- The terms of the trade are agreed between the lending agent and the borrower, and collateral is delivered.
- Once the collateral has been received by the lending agent, the lent/borrowed securities are transferred to the borrower.
- The lender (i.e. the ETF) remains the beneficial owner of the security on loan. As such, the lending agent collects all entitlements paid on each security whilst on loan and passes these back to the lender as a manufactured payment. The lender is in the same economic position as if the security had not been lent.
- The borrower pays the lending agent the preagreed lending fee. Payments are agreed and made on a monthly basis.
- The borrower returns the securities once the demand is fulfilled, or earlier if the lender liquidates a position. All trades are recallable on demand on a daily basis and no fixed term trades are entered into.
- Once the security has been returned to the lender's custody account, the lending agent returns the collateral held to the borrower.
What is the general process for Swiss UBS ETFs securities lending?
- UBS AG borrows securities from UBS ETFs.
- UBS AG provides collateral, including safety margins and haircuts (overcollateralization). A daily mark-to-market process ensures that the value of the collateral that UBS AG provides is always adjusted to the correct level.
- UBS AG will usually lend the securities in the market against a fee. These market transactions are done in the name and risk of UBS AG.
- Fees received from the market borrower are shared according to a preagreed fee split arrangement between the UBS ETF and UBS AG.
- UBS AG passes on any corporate actions to the ETF. Coupons and dividends will be paid to the ETF via a "manufactured" substitute payment ensuring the ETF is economically at least in the same position as it would be if the securities were not borrowed.
- UBS AG will return the securities to the ETF upon termination of the loan, or if the ETF wishes to regain the securities, for example in case of a sale. The ETF portfolio manager can sell securities anytime even though they are lent as securities lending does not interfere with the main investment process.
- Collateral level will be adjusted as per (2) above.
How are the securities lending loans collateralized for the Luxembourg-domiciled UBS ETFs?
Securities lending transactions for UBS ETFs set up in Luxembourg are fully collateralized. The Luxembourg regulator requires a minimum collateralization of 90%; however, UBS ETFs overcollateralize to 105%.
UBS ETFs only accept securities issued by G10 countries (except Japan and Italy), as well as Austria, Denmark, Finland, Norway and New Zealand, and world equities. The collateral is held in a custodian account that is ring-fenced from the lending agent's balance sheet. Further risk mitigation measures are careful selection of borrowers and revaluation of loans and collaterals on a daily basis.
How are securities lending loans collateralized for Swiss-domiciled UBS ETFs?
Securities lending transactions for Swiss-domiciled UBS ETFs are fully collateralized. UBS AG has a very robust collateral setup which is in accordance with the FINMA Collective Investment Schemes Ordinance.
UBS ETFs overcollateralize to a minimum of 105%. The collateral consists of liquid assets, including government bonds, liquid equities (with a 15% haircut) and bonds with a minimum rating stipulated by one of the FINMA approved rating agencies. Further concentration limits ensure proper diversification of the collateral portfolio.
A daily mark-to-market process ensures that the collateral value is adapted to reflect the loan value. Collateral is transferred in the name of the lender in a segregated collateral account which is remote from the bankruptcy estate of UBS AG.
What is the maximum amount lent from a fund for UBS ETFs?
UBS has limited lending by any one UBS ETF to 50% of its assets under management. In practice and as a rule, the proportion actually lent is significantly lower.
How should I evaluate the performance of an ETF?
The performance of an ETF should be compared to that of the index and of other ETFs on the same index. It helps to compare the performance over several years as the best performing ETF on a product can change from one year to another. For ETFs paying annual or semi-annual dividends, these payments should be reinvested in order to adequately compare them to ETFs that do not distribute dividends.
How does securities lending impact performance?
The reason ETFs engage in securities lending is the revenue gained to the fund, which positively impacts performance. For funds with highly desirable assets (from a lending perspective), such as European stocks, the extra revenue can partly or greatly offset the management fee of the fund.
Which costs can negatively impact performance?
There are several factors that can negatively impact a fund's performance:
- management fees,
- collateral costs,
- trading costs,
- rebalancing costs
- and cash drag (although, depending on index performance, cash drag has a potential to have a positive impact on performance).
These are the basic costs to manage the fund. Management fees are probably the most visible of these but are usually not the only consideration.
Trading costs, rebalancing costs and cash drag are factors that signify the importance of a skilled provider. Skilled ETF providers such as UBS have an experienced portfolio management team, dedicated index research analysts and global trading capabilities.These attributes are major factors in limiting costs that can negatively impact ETF performance.
What causes tracking error in UBS ETFs?
For physically replicated ETFs, the following may cause tracking error: different withholding taxes applied to the index vs. the fund, different reinvestment dates for the dividends, cash drag, management of index events and securities lending income. Therefore, it is important to have an experienced portfolio management team with a long track record in passive management. The UBS portfolio management team boasts over 30 years’ experience.
For synthetically replicated UBS ETFs, the tracking error is zero.
What is TER (total expense ratio)?
The total expense ratio (TER) is a measure of the total costs of an ETF. The total expense ratio is the ratio between total costs and average size of a fund during a fiscal year. Costs are all expenses in the income statement, including management, administration, custody, auditing, legal and advisory fees.
How is the liquidity level of an ETF identified?
There are two layers of liquidity when it comes to ETFs:
The first layer of liquidity for an ETF is the on-exchange liquidity for the secondary market. Designated market makers (e.g. Commerzbank in the case of UBS ETFs) have contractual agreements with the exchanges and are obliged to provide continuous quotes during trading hours, ensuring low spreads and consequently a high level of liquidity. Therefore, the number of quoted shares in connection with low spreads measures the liquidity of ETFs.
- The second layer is measured through the liquidity of the underlying assets themselves. If underlying assets in the fund are illiquid, it can lead to difficulty in the creation of new shares. Since the market maker must hedge open positions with the underlying, the liquidity of the underlying is reflected in the liquidity of the ETF on the secondary market. The easiest measure for judging liquidity is the bid/ask spread. For an investment decision, consider ETFs with small spreads and sufficient bid/ask volume.
What are bid/ask spreads?
The bid/ask spread for ETFs is the difference between the prices quoted by market makers for an immediate sale (ask) and an immediate purchase (bid). The size of the bid-offer spread in a security is one measure of the liquidity of the market and of the size of the transaction cost.
The investor initiating the transaction is said to demand liquidity, and the other party of the transaction, the market maker, supplies liquidity. Investors place market orders and the market maker places limit orders. For a round trip (a purchase and sale together) the investor pays the spread and the market maker earns the spread. The bid/ask spread is an accepted measure of liquidity costs in ETFs. On any standardized exchange, two elements comprise almost all of the transaction costs – brokerage fees and bid-ask spreads (liquidity costs).
What is OTC trading?
Over-the-counter (OTC) or off-exchange trading refers to the direct trading of ETFs between the investor and the authorized participant. It is contrasted with exchange trading, which occurs via facilities (i.e., exchanges) constructed for the purpose of trading, such as futures exchanges or stock exchanges.
Who is allowed to subscribe UBS ETF shares?
Only authorized participants who have an authorized participant contract with the ETF may subscribe.
What is an authorized participant or authorized partner?
An authorized participant or authorized partner has an authorized participant contract with the ETF. The authorized participant buys or sells shares of an ETF directly from or to the fund, which are usually exchanged in-kind with baskets of the underlying securities or in cash.
Authorized participants may wish to invest in the ETF shares for the long term but usually act as trader on the open market, using their ability to exchange creation units with their underlying securities to provide liquidity of the ETF shares and help ensure that their intraday market price approximates to the net asset value of the underlying assets.
Are there special conditions when buying ETFs through UBS e-banking?
A discount of 25% is offered on UBS e-banking for transactions up to a volume of CHF 200,000.
Is it possible to buy UBS ETFs at the Frankfurt Stock Exchange even if the fund is not registered for distribution in Germany?
A fund without distribution registration in Germany cannot be listed at the stock exchange in Frankfurt. The same would apply in Switzerland (i.e., an ETF not registered in Switzerland may not be listed at the SIX Swiss Stock Exchange).
Why is it that I cannot include any ETFs in the fund savings account (Fondskonto)?
This is because ETF shares cannot be traded in fractions.
How are precious metal ETFs physically replicated?
UBS ETFs that track physical metals invest predominantly in the respective physical metal in the form of standard bars.
How high is the counterparty risk? Can I still withdraw my metals physically if UBS has to file for bankruptcy?
There is no counterparty risk from metal derivatives as the funds invest mainly in physical metals. Lending and borrowing is not permitted. The metal bars are physically segregated and stored in a high-security vault in Switzerland.
Investors have the right to redeem in kind (i.e., in physical bars) for the standard bars. Delivery at any UBS branch in Switzerland (no physical delivery outside of Switzerland by UBS), as well as delivery to third-party banks, is offered. Because the funds are legal entities in themselves, bankruptcy of the provider (UBS) would have no impact on investors' ability to redeem in kind or via an exchange.
How does the currency hedge work for commodity ETFs? How high is the residual risk in CHF or EUR against the USD?
It is the calculation of the hedged index that the investor should consider when looking at the currency risk. The currency impact of the hedged index on the base currency index is minimal as the hedged index is calculated daily by applying the correct FX rate to the base currency index.
Are dividends paid out on UBS ETFs?
UBS ETFs are distributing and pay out dividends if the underlying securities in the fund distribute dividends. The equity and real estate UBS ETFs established in Switzerland normally distribute dividends twice a year. Interim dividends are also possible.
The physically replicated UBS ETFs domiciled in Luxemburg and Ireland distribute the accrued dividends (on equity ETFs) and coupons (on bond ETFs) twice a year. Interim dividends are possible here as well. By contrast, the synthetically replicated UBS ETFs domiciled in Ireland reinvest (accumulate) the dividends. Precious metal ETFs are set up as distributing funds.
When are dividend payments made?
As a rule, for physically replicated ETFs established in Luxemburg and Ireland, interim dividends are distributed in July and final dividends are paid in January. For ETFs domiciled in Switzerland, interim dividend payments may be spread out over the year.
Are dividends distributed gross or net?
UBS ETFs domiciled in Switzerland normally distribute net dividends. UBS ETFs with tax domicile in Luxemburg and Ireland pay gross dividends as a rule.
Where can I find information on dividend payments?
UBS publishes ex-dates and payment dates on its website: www.ubs.com/etf.