UBS ETFRetail Investors in the Netherlands:
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).
Use of derivative instruments to replicate index (e.g. swaps)
ETF invests into all constituents of the Index with the same weightings
ETF invests into a subset of Index constituents based on optimized replication methods which represents risk and performance measures of the Index
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%.
As with physical replication, synthetic ETFs track a particular index. However, instead of physically holding each of the securities in the index, a synthetic ETF relies on derivatives such as swaps to implement its investment strategy. These derivatives are agreements between the ETF and an approved counterparty that pay the ETF the return of the relevant index.
For most UBS synthetically replicated ETFs, the ETF invests into a [physical] portfolio of securities, and then trades derivatives under which it swaps the return of this portfolio for the return of the index it is tracking (after fees and expenses). The securities held in the portfolio are not required to be a constituent of the tracked index.
For certain exposures the synthetic ETF does not invest into a physical portfolio of assets, but uses the cash from investors to purchase a derivative from the approved counterparty under which it receives the performance of the tracked index.
Why do some ETFs use synthetic replication and some physical replication?
Physical ETFs attempt to track their target indices by holding all, or a representative sample, of the underlying securities that make up the index. This straightforward approach works well for many traditional indices.
However, because they don't need to physically hold the securities in which they invest, synthetic ETFs can provide a more efficient replication method for investors seeking to invest in harder-to-access markets, less liquid benchmarks, or other difficult-to-implement strategies that would otherwise be very costly or difficult for physical ETFs to track. Physical replication of certain indices can be challenging, especially in tracking of indices containing markets with trade restrictions, property restrictions, or where trading occurs in different time zones.
One further advantage of synthetic replication is the reduction of tracking error. The tracking error measures the volatility of the difference of the return of the ETF and the return of the reference index.
What are the costs and fees for UBS ETFs?
All UBS ETFs are charged a fixed fee called the [Total Expense Ratio] which comprises all the ETF’s operational and administration costs, the management fee, costs of prescribed documentation, legal and audit fees, and licensing fees.
Physical ETFs will have additional costs related to the trading of physical securities to replicate the index.
Synthetic ETFs will have additional costs related to the costs of trading derivatives with the approved counterparty.
Who are the approved counterparties for synthetic UBS ETFs?
UBS AG, London branch is the counterparty to UBS ETFs.
UBS credit ratings are Standard & Poor’s: A (November 29, 2011) and Moody's: A2 (June 21, 2012) (as of August 2013).
If trading of derivatives results in counterparty exposure how is this addressed?
Any counterparty risk created through use of derivatives is addressed through daily posting of collateral under terms agreed upfront with the counterparty. Collateral is held in a segregated account with an external custodian bank in the name of the ETF (sometimes known as "transfer of title").
For UBS synthetic ETFs only G10 government bonds, certain supranational bonds and cash are eligible as collateral.
Who acts as the Custodian for any collateral held by UBS ETFs?
State Street acts as custodian bank for swap collateral of all synthetic 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 amount of collateral required calculated and existing collateral marked-to-market?
Are haircuts applied to any non-cash collateral?
A Haircut is a safekeeping measure used by the ETF to ensure that securities received as collateral adequately cover the related exposure to a counterparty.
The exact Haircut used varies according the collateral being posted, but for all UBS synthetic ETFs any non-cash collateral has some level of haircut applied which means in order to collateralize, for example an exposure of USD 100k in a Government Bond requires more than 105% of the value of the relevant security to be posted by the counterparty.
Under UCITS regulations, a fund may not have a counterparty exposure greater than 10%.
What happens if the approved counterparty 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.
In the event the approved counterparty was to default UBS Asset Management on behalf of the fund would either:
- find a replacement approved counterparty; or
- Liquidate the security portfolio/collateral held by the fund and return the proceeds to investors.
Given such a default would likely occur in a time of significant market stress it is likely option 2 would be taken unless a replacement was readily available.
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 have accumulating and distributing share classes. Accumulating share classes re-invest the dividends paid by the underlying index’ constituents and are therefore reflected in the NAV of the relevant ETF rather than distributed. Distributing share classes of 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. Precious metal ETFs are set up as distributing funds.
When are dividend payments made?
As a rule, for distributing 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: