Competitive pressures in the index-tracking business have been building for some time. BlackRock’s application to US regulators to do its own indexing has been in the headlines for months, but in the end it was BlackRock’s arch-rival, Vanguard, which dropped a bomb on the index industry by ditching MSCI yesterday as the benchmark provider for some of its biggest tracker funds.
At first glance the dramatic reaction in MSCI’s share price—it fell 27 percent in Tuesday trading in New York—looks overdone. MSCI earned over US$900 million in revenues last year and is facing the loss of less than 3 percent of that total as a result of the departing Vanguard business. And yet the index firm suffered a decline yesterday of over US$1 billion in its market capitalisation.
(As a side-note, the lost revenue reported yesterday by MSCI—US$24 million—allows us to calculate the average index licensing fee Vanguard was paying the index provider: on the departing US$537 billion of assets, it works out as 0.45 basis points a year).
But if one considers that Vanguard’s switch is likely to result in other index licensees queueing up for fee cuts—and not just at MSCI—then the market’s savage reaction to yesterday’s news becomes more understandable.
Up to now the index industry has been regarded as one of the few bright spots in a shrinking financial services sector. MSCI, for example, has more than doubled both revenues and income over the last three financial years. Yesterday that handsome growth rate suddenly looked like a thing of the past, at least for the index provider segment of the passive funds business.
To me, the most interesting aspect of Vanguard’s decision is what it says about how fund management firms are owned and structured.
The fund at the centre of yesterday’s announcement, Vanguard’s US$67 billion MSCI Emerging Markets ETF (NYSE Arca: VWO), is in fact part of a larger legal vehicle, which also incorporates daily-dealing “admiral” and “investor” shares (ETFs trade continuously). It’s worth noting that the name for the two non-ETF share class categories is the “Vanguard Emerging Markets Stock Index Fund”, with no mention of the index provider.
Vanguard has been grumbling off-the-record about what it sees as unjustified index licensing fees for some time. Now, it’s making a statement that its own brand name means the most to the man in the street, with the identity of the benchmark being of secondary importance. Whether South Korea should be classified as an emerging market or not (the country is in MSCI’s EM index, but not in FTSE’s) may get some indexing nerds excited, but Vanguard is betting that investors trust the firm to do the right thing when choosing the basis for its tracker funds.
iShares took a very different tack in a public statement yesterday, with Mark Wiedman, global head of BlackRock’s ETF business, calling MSCI’s benchmarks “the gold standard of global and international equity indices.” Wiedman’s comments suggest that BlackRock’s self-indexing ambitions remain modest, but they also mean that the firm has no intention of fighting a head-to-head, almost certainly losing battle with Vanguard on costs.
In contrast, one major reason why Vanguard may be able to get away with downgrading the role of its index providers is the firm’s mutual ownership structure. Investors trust, in other words, that Vanguard is less prone than other firms to the conflicts of interest that have shredded consumer confidence in the financial services business.
The firm isn’t always on the side of the angels—it recently sided with the investment industry and against its founder, John Bogle, on reform of the US money market sector, an area where most disinterested observers see an urgent need for change in view of the hidden risks posed to the taxpayer.
But Vanguard is putting a greater squeeze on its rivals than ever before. The dramatic market impact of yesterday’s announcement of a change in index providers shows that the business models of competing firms face increasing turmoil.
Bogle has long argued that the “mutual” fund industry is a misnomer, with funds being set up and run more for the benefit of industry insiders than for the end-investor. Meanwhile, Vanguard describes itself as “the client-owned investment management company built to put your interests first”. Isn’t it time for some real fund management mutuals to be set up to take on Vanguard’s challenge?