How is an index incorporated into a portfolio?

The objective of an exchange traded fund (ETF) is to track as closely as possible the index on which the ETF is based in order to provide investors in the ETF the same performance relative to the market underlying the index.

Indices are based on theoretical calculations, however, which means that costs incurred in practice, for example, for the purchase or sale of securities represented in the index are not reflected in the index calculation. Nevertheless, these costs are charged whenever an index and its performance are replicated for an investment.

How closely an ETF tracks the performance of its underlying index is therefore critical. Ideally, the performance of the ETF differs from that of the index solely in the costs and fees incurred. Since for example indices tracking only the stock market of a single country apply different criteria for index replication compared to an index containing stocks from multiple countries, the criteria for an exact index replication differ from index to index. For these reasons, UBS ETFs utilize a variety of index replication methods.

The purchasing process is in principle identical for all replication methods – however, physical delivery of the securities applies only to physically replicated ETFs.

1. The investor purchases ETF units on the stock exchange or directly from a market maker or authorized partner (OTC trading)
2. The market maker or authorized partner either pays cash (for physically and synthetically replicated ETFs) or delivers the requisite securities (only for physically replicated ETFs) to the ETF

In the case of full physical index replication, the ETF acquires all securities represented in the underlying index in accordance with their index weightings. Hence, the ETF is in physical possession of the index components and thus an exact replica of the index. If any changes are made to the index, for example through index adjustments or capital actions of the represented securities, the ETF replicates these changes, making transactions necessary on a regular basis. The ETF regularly distributes income, in the form of dividends or coupons for example.

The full physical replication method is characterized by simplicity and minimal tracking error.

1. The ETF is in physical possession of all securities represented in the index in accordance with their index weighting
2. All index adjustments and capital actions are identically replicated
3. Some ETFs lend out securities from their portfolio for a fee

Securities lending

A number of select physically replicated ETFs engage in securities lending in order to generate additional returns and reduce investors' net costs, whereby the ETF's securities are lent out for a fee. Securities lending transactions of UBS ETFs are overcollateralized to a minimum of 105%.

In the case of optimized physical replication, the ETF holds a sample of the securities in the underlying index. Analytical tools and mathematical optimization procedures are implemented to define a subset of the index constituents that will achieve a return similar to that of the original stocks represented in the index. The optimized physical replication method can be utilized to increase liquidity and minimize tracking error.

The optimized physical replication method is particularly suitable for very broad-based indices. For example, the MSCI World Index comprises approximately 1,600 stocks from a variety of markets, jurisdictions and currency zones. Accordingly, full physical replication of the index would involve high transaction costs. A number of these securities are not very liquid or have only minimal impact on the performance of the Index due to their low weighting. Transaction costs can be reduced by excluding these securities.

1. The ETF is in physical possession of a subset of the index components, which is used either for very broad-based indices or for indices with illiquid securities
2. Optimization procedures are implemented in order to lower transaction costs, increase liquidity and minimize tracking error
3. Some ETFs lend out securities from their portfolio for a fee 

Securities lending

A number of select physically replicated ETFs engage in securities lending in order to generate additional returns and reduce investors' net costs, whereby the ETF's securities are lent out for a fee. Securities lending transactions of UBS ETFs are overcollateralized to a minimum of 105%.

In the case of synthetic index replication, the performance of the index underlying the ETF is achieved through a swap. The ETF enters into a swap agreement with an investment bank, the swap counterparty. The content of this agreement is the transfer of the ETF's cash flows to the swap counterparty, which in return guarantees the performance of the tracked index to the ETF. The risk associated with precise index tracking is transferred from the ETF to the swap counterparty. As physical ownership of the securities represented in the index is no longer a prerequisite for participation in the index performance, it is possible to efficiently track markets that for example are impossible or difficult to access due to trading restrictions.

UBS employs two different swap structures in synthetic replication: the fully funded swap and a combined model (fullyfunded swap / total return swap and asset portfolio).