Vanguard’s recent decision to switch benchmark providers on half a trillion dollars of assets has thrown the indexing world into turmoil.
What’s an index worth to its provider? Putting this another way, how much should an investor expect to pay for the benchmark underlying an index-tracking fund?
Industry participants offer very different answers to this question, revealing tensions that go to the heart of how the asset management business operates.
A radical view of the indexing world, but one that’s apparently gaining traction, suggests that only a few large equity benchmarks have real brand value.
According to Steffen Scheuble of index provider Structured Solutions, maybe 10-20 indices worldwide fall into this category. He didn’t tell me what he thinks they are, but we can probably all come up with the likely names—S&P 500, MSCI World, Dow Jones Industrial Average, FTSE 100, Euro STOXX 50, Nikkei 225, DAX, CAC 40, plus a few more.
A couple of weeks ago I’d have added the MSCI Emerging Markets index to the list, but Vanguard’s recent decision to ditch that benchmark for a lower-cost index offered by FTSE suggests that the premium brand-name group might be shrinking.
Scheuble’s firm, and others of its type, offer to undercut the prices charged for brand-name indices by providing a slimmed-down service focusing on calculation and index maintenance only. This approach is bringing in a large volume of new business from cost-conscious product issuers, Scheuble says.
According to one index industry veteran, who spoke to me on condition of anonymity, a large indexing firm like BlackRock—and the investors in its funds—could easily save tens of million dollars a year in licensing fees by abandoning the majority of branded indices they pay for, internalising the index design and outsourcing the index’s calculation and maintenance functions to low-cost providers. This basic service can apparently cost as little as a few thousand dollars a year per benchmark.
By contrast, says my industry contact, most index providers currently charge between six percent and 12 percent of an exchange-traded fund’s total expense ratio under the AUM-based licensing model that’s become standard across the industry over the last two decades. It’s that AUM-based fee scale that’s now under open attack.
And there are stand-out licensing fees, too, some falling well outside that 6-12 percent (of TER) range.
State Street Global Advisors’ US$116 billion S&P 500 tracker (NYSE Arca: SPY), the world’s biggest exchange-traded fund, pays a whopping 33 percent of its annual net expense ratio (3.1 basis points out of 9.45 bp) to S&P Dow Jones for the provision of the 500-stock index, something that’s set in stone in the fund prospectus. That’s a cool US$36 million a year in fees to the index provider from a single ETF.
So no wonder BlackRock has applied to the SEC to develop the benchmarks for its own funds. And now Vanguard has shattered the uneasy ceasefire over index costs, the sheer scale of the potential savings involved suggests that MSCI, the big loser from Vanguard’s recent switch, shouldn’t be too reassured by recent comments from iShares head Mark Wiedman that MSCI’s indices represent a “gold standard”.
But not so fast, say the index firms.
It’s worth paying the cost of hiring an independent index provider, says Alex Matturri, CEO of S&P Dow Jones Indices.
“Self-indexing defeats the idea of an ETF as a transparent product. The brand associated with an index is important. It gives the investor knowledge of the process, of the role of the index provider—we are not a product issuer—and it takes away the issue of conflict of interest. The ETF business has done remarkably well because of its traits such as transparency. Self-indexing takes some of that away. The transparency isn’t the same,” he said in a recent interview with IndexUniverse.
The recent LIBOR scandal and the evident conflicts of interest surrounding some of the financial industry’s previously self-managed benchmarks show that we shouldn’t automatically equate indexing with good value or even fair practice.
And the index firms’ increasing involvement in important questions of corporate governance demonstrates that, like it or not, benchmark providers have already moved far from their original role of statisticians calculating a market average.
Two other factors make it even harder to decide where the real value lies in the fund manager/index provider relationship.
First, there’s the increasing involvement of index firms in so-called strategy (or “smart beta”) indexing, where an investment strategy is embedded in the index itself.
Index firms argue that a lot of what has traditionally been presented as asset manager skill (and sometimes offered with steep hedge-fund-type fees to boot) can be offered in a simple, replicable, index-based format. And index providers say that they are as well placed as anyone else to offer this service, particularly given that fund managers or banks may suffer from internal conflicts of interest.
Imagine a large fund management firm offering a similar, systematic (formula-based) equity strategy both via an index-based ETF and a hedge fund, with the latter offering a much higher earnings stream via performance fees. All the leading ETF providers are part of larger fund management concerns, all of which promote much higher-margin active products as well. How incentivised are they going to be to push the cheaper, ETF version of a strategy to clients?
But delegating a fund’s investment strategy to an indexing firm is a controversial idea. According to one fund manager, who spoke to IndexUniverse.eu recently on condition of anonymity, investing should be left to those charged formally with an asset management role, and not outsourced to benchmark providers.
“We pay the costs of a mistake if something goes wrong with a client’s money, so index firms shouldn’t be providing investment advice unless they are willing to be regulated and bear the associated burden,” said the fund manager.
Stephan Flagel, formerly head of indices at Markit, agrees.
“It’s odd that ETF sponsors pay index providers such a high share of their revenues for investment strategy or ‘enhanced beta’ indices,” says Flagel.
“Developing investment strategies is a core capability of asset managers, so why should they hand this competency over to index providers? Indeed, many of these indices are developed in close cooperation with the asset manager or ETF sponsor. So why are ETFs paying high index fees based on AUM, instead of a small fixed fee for calculation services?” he says.
But regulators may make the debate over smart beta moot anyway. The European Securities and Market Authority’s recent decision to insist on full transparency for the indices underlying European retail investment funds leaves index firms with a dilemma: if they continue offering investment strategies in index format they will risk giving away the “secret sauce” or intellectual capital behind the index idea as a result of the new transparency rules.
The net result of regulators’ demands for index transparency is that we’re going to see a large-scale move towards non-transparent, active ETFs that don’t track an index in the first place, Flagel says. From passive back to active, in other words.
There’s no sign yet that the indexing boom has peaked. There are still far too many poor-value active funds that are likely continue to lose money to cheaper, formula-based alternatives. But recent events have the feel of an important inflection point for the index industry and are a sign that competitive pressures have moved to a new level.
All this should ultimately be good news for investors, who will benefit from lower fees. But business models are currently in turmoil, and important questions over the rights and responsibilities of the different players in the index fund management business remain unanswered.