In the great scramble to find innovative ways to reduce costs within the asset management space, index firms are becoming an increasing focus of attention.
Most fund managers now realise that running an index firm can prove fabulously profitable. The big firms, such as MSCI and S&P Dow Jones are not only riding the wave of the passive funds revolution but also continuing to pick up juicy revenues from diverse products including expensive data usage licences and benchmarking fees. Many fund managers I run into have a resigned attitude to forking out these fees, regarding them as an expensive necessity.
But ETF managers are now beginning to fight back. For these outfits index fees are an increasingly large bit of their total cost matrix – and as charges continue to head towards zero, a barrier to profitability. The resulting fightback takes various shapes.
Some managers are taking back their indices in house. State Street for instance has just announced that it is dumping FTSE Russell as its small and midcap index provider, preferring to use in house indices calculated by NYSE.
The relevant ETFs are
• The SPDR Portfolio Total Stock Market ETF (SPTM), which will now track the SSGA Total Stock Market Index
• SPDR Portfolio Large Cap ETF (SPLG), which will now track the SSGA Large Cap Index
• SPDR Portfolio Small Cap ETF (SPSM), which will now track the SSGA Small Cap Index
In truth this isn’t an entirely new development as ETF issuers such as Wisdom Tree have been self indexing for many years.
Arguably a more worrying development is that innovative, new ETFs – many of them tracking new themes – have also been making headlines. Crucially many of these heavily marketed new funds feature an independent index provider. ETFs such as MAGA – Make America Great Again, BIBL – Christian Objective ETF, EMTY – Decline of Brick and Mortar Retail and CARS/U – Robotic Cars, have shied away from the major index providers (or feature an active fund manager).
According to Bernie Thurston at Ultumus, two forces are at work: major index providers have become too reliant on legacy industry classification systems, and ETF issuers are pushing down costs.
According to Thurston, none of these new thematic ETFs have been created with “any conventional classification system (like the Global Industry Classification Standard or the Industry Classification Benchmark.) And this could be a sign of what the future holds. Why did the big firms fail to keep up? Partly because their classification of industries and sectors is somewhat out of date. The Global Industry Classification Standard, the most widely used classification system, was launched in 1999. Yet social media – an industry with hundreds of billions in market capitalisation – didn’t take off until the mid-2000s. Index providers proposed changes to GICS this year, but this is may be too little too late”. Thurston believes until “a new classification system is designed around the newer technologies” the legacy index firms are in trouble in growth markets.
Cost is the other crucial driver. Thurston observes that “Companies like Solactive, the German data company, charge small flat fees for their indexes rather than a fixed share of AUM (the old deal used to be 3 basis points for an index). The Solactive 500 large cap index, for example, competes with the S&P and, while it doesn’t have the brand name, functions in a very similar way and is drawing more and more market share”.
The bottom line for legacy index providers? Slow decline. Beyond the long established, widely known benchmarks “the future of indexing could be an open question with ETF providers fulfilling the role of index providers as well” says Thurston.
This all sounds very sensible and one part of me hopes that Bernie is right. Any industry that is dominated by just three or four major global firms is wide open to the charge of oligopoly, and thus ripe for technological disruption.
Safe for now
But my own suspicion is that the big firms are probably safe now – for three simple, arguably very cynical reasons.
First, the regulators will prefer it that way. In simple terms at some point in the not too distant future they’ll need someone to blame if all this index tracking stuff goes wrong, and better to have someone to blame with deep pockets. The regulators are already deeply suspicious of big investment banks self indexing, arguing for proper external validation. The deeper problem though is that in any future ETF blow up, the regulators will want to see a trail of evidence and decision making that will point back to a major systemic institution. And that target will be an index firm.
Next up, the consumers of indices will also seek solace in well known brand names, especially in the retail space. Imagine an adviser trying to explain why they bought a US equity main market tracker which features an unknown name – many clients might demur and say whats “wrong with the index everyone knows”?
But this in built psychological bias in favour of big, familiar brand names extends beyond the major benchmarks into alternatives – arguably its even more important that a well known index provider provides a product in a niche, as it suggests that ‘the big guys’ take this alternative seriously.
Last but by no means least, the big index firms are experts in providing the collateral intellectual property that goes with running an index. They can churn out research papers, constantly put up experts about every form imaginable of smart beta for instance and generally send someone to every conference going. This depth in IP is valuable and expensive to maintain. It is in effect a drain on resources but it provides massive validation. Its also incredibly difficult to sustain for smaller independent firms.
To be fair these outfits are fighting back though, as evidenced by Solactive releasing an excellent paper just this morning about robo advice. But in truth the wall of IP and incremental research is just too great for the rivals to challenge.
Over time I hope this will all change but for now I am sceptical. My guess is that the big index firms are safe for now.