ETF Report




The Euro Stoxx 50 Index includes 50 large-cap companies from 12 developed countries in the eurozone. To be eligible for inclusion, a company must be headquartered in a country of the European Economic and Monetary Union. In order to construct the index, Stoxx identifies stocks that represent the largest 60% of each Super Sector (there are 19) by free-float market cap. It ranks the stocks on the resulting list by free-float market cap and targets the largest 50 for inclusion in the index. Each component is capped at a maximum of 10% of the index's overall value. In order to reduce unnecessary turnover, the largest 40 stocks are included in the index. The remaining 10 stocks are chosen from stocks with a rank between 41 and 60. This adjustment, together with market-cap weighting, has kept the index’s turnover low. Its turnover was in the single digits in each of the past five years. At the time of writing, financials is the biggest sector represented, constituting 17% of the index's value, followed by consumer discretionary (13%) and industrials (13%). French and German companies combined account for about 70% of the index. Spanish and Dutch companies represent another 20%, and the remainder is spread among another eight countries. The index is well-balanced from a single-stock perspective. The top components of the Euro Stoxx 50 are Total, SAP, and Sanofi, with a 3%-6% weighting each.

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At 0.15%, this fund's ongoing charge is in the middle of the range for ETFs tracking the Euro Stoxx 50 Index. Today, there are rival ETFs charging fees as low as 0.05%. That said, one should look beyond fees and examine the total holding cost per year, as measured by the tracking difference (fund return less index return). Most, if not all, Euro Stoxx 50 ETFs exhibit positive tracking differences (meaning they outperform the index) because of differences in withholding tax treatment between the funds' and the index's methodology (the funds enjoy a better withholding tax rate on dividend than the Euro Stoxx 50 Net Return Index). The UBS (LU) Euro Stoxx 50 ETF has outperformed its benchmark over the trailing five-year period by an annualised 0.53% per year. Additionally, an ETF investor will typically have to pay trading costs, including bid-offer spreads and brokerage fees, when buy and sell orders are placed for ETF shares.

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This fund uses full replication to track the performance of the Euro Stoxx 50 Net Return Index. The fund invests in all the constituents of the index with the same weightings stipulated by the index. Routine cash stock dividends are reinvested according to index rules using an "overdraft" facility available from the custodian, State Street Bank. This practice helps reduce tracking error. The fund engages in securities lending to help improve tracking performance. Gross lending revenues are split 60/40 between the fund and lending agent State Street Bank, respectively, while the latter covers all the operational costs. In the 12 months to this writing, the fund lent out 2% of its assets on average and a maximum of 4% at any point in time. The activity generated 0.03% of net revenue for the fund. Although this activity serves to enhance returns, it also introduces counterparty risk. To protect the fund, borrowers are requested to post collateral equivalent to 105% of the loan value. Counterparty risk is monitored on a daily basis by the lending agent. As a general rule, the amount of securities that can be lent by the ETF at any point in time is capped at 50% of its net asset value. To further mitigate counterparty risk, State Street also provides borrower default indemnification in the event a borrower is unable to return the securities. UBS ETF business is efficiently run by a team of experienced professionals. The company runs a mixed physical/synthetic product line up with a strong bias to equity market exposures. The fund management process is focused on achieving cost efficiencies, although this does not necessarily lead to lower ongoing charges.

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The Euro Stoxx 50's mega-cap focus doesn't give us confidence in UBS Euro Stoxx 50 ETF's ability to outperform Morningstar Category peers over a full market cycle on a risk-adjusted basis.

The Euro Stoxx 50 Index is a widely followed benchmark to gauge investor sentiment on eurozone equities. But with only 50 components capturing 60% of the euro area's total market value, it stands as a narrow investment proposition that does not represent the opportunity set available to investors. The eurozone large-cap equity category includes passive and active funds that are better diversified.

Because of its concentration in giant caps--and lack of tailwind generally provided by "smaller" caps at times of strong economic growth--the exchange-traded fund is unlikely to outperform its category peers over the long term.

That said, its risk-adjusted returns have been marginally better than average during the trailing three and five years but have been poor over 10 years. The fund has held up better in times of market downturns and uncertainty when investors tend to flee to the safety of blue chips.

That said, there is no shortage of passive funds offering exposure to the popular Euro Stoxx 50, many of which have seen their fees slashed in recent years. At 0.15%, this fund is one of the lowest-cost funds in the category, but cheaper directly comparable peers to exist (for example, Xtrackers Euro Stoxx ETF at 0.09%).

Like most Euro Stoxx 50 Index funds, this ETF outperforms its index because it enjoys a better withholding tax rate on dividends than the Euro Stoxx 50 Net Return Index. It also benefits from securities-lending activities.

Ultimately, because of its narrow mega-cap mandate, the Euro Stoxx 50 Index represents a less-than-ideal option for investors seeking long-term exposure to eurozone large caps. For this reason, we have awarded the UBS Euro Stoxx 50 ETF a Morningstar Analyst Rating of Neutral.

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Fundamental View

Passive investors in eurozone equities have a small range of cap-weighted funds from which to choose. Of these, the most tracked index by ETFs in Europe is the Euro Stoxx 50. Tracking only the 50 largest companies in the monetary union, the index is extremely narrow and only provides targeted mega-cap exposure.

Broader in terms of size, with around 240 constituents, is the MSCI EMU Index. Like other MSCI indexes, it captures approximately 85% of the free-float-adjusted market capitalisation and is designed to measure the performance of the large- and mid-cap segments of the eurozone equity market.

More comprehensive still is the Euro Stoxx Index, which spans around 300 constituents. It represents eurozone-screened subset of the wider Stoxx Europe 600 Index and is the broadest passive index currently tracked by European funds.

We hold a general preference for a broader cap-weighted index as those tend to be more representative of the total market and therefore a more comprehensive building block. The broader the index, the harder it becomes for active managers to boost relative returns over the long term through stock selection.

Over the trailing five-, 10-, and 15-year periods (to March 2019), index Sharpe ratios have matched theoretical predictions remarkably well. The broadest offering, the Euro Stoxx Index, has been the top performer, with the highest Sharpe ratio, followed closely by the MSCI EMU Index. Trailing both by some margin over the same periods is the Euro Stoxx 50 Index. While the breadth to risk-adjusted performance relationship may not hold over shorter time horizons, we are confident that broader indexes will demonstrate their superiority over longer time frames.

Like in most other developed markets, over the trailing 15 years, mid- and small caps have outperformed their larger counterparts. This has seen blue-chips stocks surrender a percentage of overall market to their smaller counterparts, increasing the importance of capturing the eurozone mid-cap segment.

In theory, mid- and small caps have a greater growth potential than their larger, often more mature counterparts and are expected to grow more rapidly in up markets. Conversely, they are riskier (fewer eyes on their financial dealings, less diversified revenue streams, less credit available, and so on) and likely to be hit hardest in market downturns.

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The Euro Stoxx 50 is the most widely tracked index to gain exposure to eurozone equities, so there are plenty of alternatives available. IShares Core Euro Stoxx 50 (ongoing charge: 0.10%) and Xtrackers Euro Stoxx 50 ETF (0.09%) are among the cheapest and best-performing.

Investors looking for a more comprehensive exposure to eurozone equities, including large- and mid-cap stocks, can consider ETFs tracking the MSCI EMU Index. ETFs tracking the Euro Stoxx will additionally provide some small-cap exposure.

Other options, albeit less directly comparable, include ETFs that track the MSCI Europe and the Stoxx Europe 600 indexes. These provide broader exposure to European equities, including equities from non-EMU countries like the United Kingdom and Switzerland. Here, there is again no shortage of options.

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