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What’s An Index Worth?

Written by Paul Amery

October 17, 2012 11:15 (CET)

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.

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