UBS' trigger PLUS linked to WisdomTree Japan Hedged Equity fund neutralizes yen exposure

By Emma Trincal

New York, March 21 - UBS AG, London Branch's 0% trigger Performance Leveraged Upside Securities due Oct. 6, 2016 linked to the WisdomTree Japan Hedged Equity fund give investors a very specific benefit: a pure equity play that removes currency risk, said Tim Mortimer, managing director at Future Value Consultants.

The underlying fund offers exposure to the Japanese equity markets while hedging against fluctuations of the Japanese yen relative to the dollar, according to an FWP filing with the Securities and Exchange Commission.

In addition, the notes offer a leveraged upside with some contingent protection.

The payout at maturity will be par of $10 plus two times any fund gain, up to a maximum return of 35.6%. Investors will receive par if the shares fall by up to 10% and will be fully exposed to the decline if the fund falls below the 90% trigger level.

"The notes have embedded costs due to the cost of hedging currency risk. But for an investor seeking a pure equity play in a non-U.S.-denominated equity fund, the benefits may offset the cost," Mortimer said.

Quanto

With the notes, investors have exposure to what is called a quanto product. The term refers to any structured product where the underlying asset is not in the same currency as the currency of the notes, he said.

"With this WisdomTree fund, the currency fluctuations do not impact your return. You are neutral the Japanese yen. All you care about is the performance of the Japanese stock index itself. The benefit for you is that a weakening of the Japanese yen relative to the dollar is not going to have a negative impact on your return," he said.

Removing currency risk is a valuable feature for investors in global equity, he said.

"Take for instance the Euro Stoxx, an underlying denominated in euros. You buy it in dollars, convert it in euros, receive your return in euros and finally liquidate it to convert it back in dollars. When you do that, you're obviously exposed to the currency risk. If the euro depreciates against the dollar, your return will be less," he said.

"A structured product is almost always calculated quanto. The currency risk is removed.

"Typically, the bank purchases in the local currency and then reverses the exposure by doing an offsetting currency trade on the FX market. It involves a little bit of transaction cost, depending on the level of differential between the interest rates of the two countries."

With the UBS product, however, the underlying fund itself is a quanto fund, he noted.

"You are buying the Japanese stock market. If the equity return is a 25% positive return, you're getting 25% irrespective of what the yen is doing," he said.

"Usually the hedging of a fund is more difficult than the hedging of an index because the options are less liquid. The fact that the underlying fund here is already hedged makes it easier to put a hedge for the notes."

The product offers two-times upside participation with a 35.6% cap, which means that investors will hit the cap if the fund is up 17.8%. The maximum return is 12.9% compounded per annum.

Higher market risk

While they insulate investors from currency risk, the notes do not necessarily do a good job in terms of market risk, he said. In fact, quite the contrary, according to the scores computed by Future Value Consultants.

The research firm measures risk on a scale of zero to 10 with its riskmap. The riskmap is simply the sum of two risk components: market risk and credit risk.

With this product, the 4.33 market riskmap is higher than average. The greater risk is visible when compared not only to the average score for products of the same type (2.55) but also the average score for all products (2.98).

One possible explanation, said Mortimer, is that currency hedging can make the return more volatile.

Hedge and volatility

When removing a hedge, some of the positive effects of currency may offset some of the negative equity returns, he explained.

He offered the following example: If the Japanese yen depreciates against the dollar, Japanese exportations should be cheaper, which usually benefits the economy. If it's good for the economy, it's usually a positive for the stock market as well, at least in the short term, he said.

"That's the reason why the depreciation of the yen would usually go hand in hand with the appreciation of the Japanese stock market," he said.

"If you buy the fund unhedged, those two effects offset one another. The positive impact on the stock market is offset by the depreciation of the yen. Stocks are up, the Japanese yen is down: it flattens out the overall return.

"So an underlying fund that is unhedged will tend to be less volatile. Inversely, when the underlying is hedged as it is the case with this underlying fund, it tends to be more volatile."

The WisdomTree Japan Hedged Equity fund has an implied volatility of 23.45%. The S&P 500 index in comparison has a volatility of 11.50%.

"Volatility is probably the main factor driving the higher market risk, which is indeed higher, especially when compared with the average of all products, a universe that is often rather volatile as it is heavily populated by reverse convertibles," he said.

"This product is also one of the most risky of the entire leveraged return category, and it's due to the underlying.

"It's probably not due to the barrier because some products have no barrier. A 10% barrier is not very deep, but at least it's there.

"This note is not designed for the very bullish investor. If you decompound the annualized return, you only need a 6.70% gain to get your full return.

"Asking the fund to go up 6.70% is very realistic. It's not an excessive requirement. If you are moderately bullish, this product makes sense."

On the credit risk scale, the score is 0.58, slightly less than the 0.64 average credit riskmap for products of the same type.

Adding credit riskmap and market riskmap gives an overall level of risk (4.91 riskmap) that is higher than the average riskmap for the category at 3.19 and for all products at 3.48.

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

The bull scenario is in this case the optimal one.

The return score of the notes is 7.34 versus an average of 7.78 for the leveraged return category.

"The hedging is more expensive, and that probably has an impact on your return. The fund itself is a little more expensive," he said.

The expense ratio for the WisdomTree Japan Hedged Equity fund is 48 basis points. In comparison, a much more liquid fund with no currency exposure, such as the SPDR S&P fund, has a 9 bps expense ratio.

"But if you have a strong view on the Japanese equity market, you are suffering a little bit extra fees because of the hedging, but if you are correct, this underlying will make up for the fees several times over. It is not the cheapest fund, and our scoring is based on the fees," he said.

Mortimer explained that investors pay for a very targeted view, which is often one of the most valuable features a structured product can offer.

"It costs a little bit more to design a product that seeks to offer a target view. Here the target is your direct exposure to the Japanese stock market without the currency exposure. Structured products allow you to follow a specific plan. You don't want too many variables. When you have too many variables, for instance the currency and the equity view, one may go up and the other go down," he said.

"On the contrary, if you have a very precise view on the Japanese equity benchmark, your payoff is linked to that and nothing else. This is what you're paying for.

"Being right on the stock market and losing on the FX doesn't make much sense. There is no point in investing in a structured product if your view is muddled. So in that regard, taking away the currency exposure makes a lot of sense."

But it comes at a cost.

Price, overall scores

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The 7.22 price score of the product is higher than the average in the leveraged return category, which is 7.68.

The higher price score can be analyzed in the same way.

"Yes, you are giving away half a point in price score. But if you want a product with a very specific view, you have to be prepared to tolerate a slightly higher fee, which deflates our score but allows you specifically to do what you want to do," he said.

Overall score

Finally, the overall score measures Future Value Consultants' general opinion on the quality of a deal. The score is simply the average of the price score and the return score.

The notes received a 7.28 overall score, compared with an average score of 7.73 for products of the same type.

"The overall score is lower than average, which is not surprising given that both the return score and the price score are lower as well," he said.

"This doesn't mean that the product is bad. The notes enable you to pursue a very specific objective. It just comes at a cost."

UBS Securities LLC is the agent with Morgan Stanley Smith Barney LLC as dealer.

The notes (Cusip: 90272V137) are expected to price March 31 and settle April 2.

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