Vanguard ETF index switch could help BlackRock

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Helping: Joel Dickinson says Vanguard made the ETF indexing switch 'in the best interests of investors.'

The biggest winner in The Vanguard Group's move to reduce costs by switching to two lower-priced index providers for 22 of its exchange-traded funds could be its competitor, BlackRock (BLK) Inc. (BLK)

While Vanguard officials say they plan to pass along cost savings to customers over time, a more immediate effect could be that BlackRock, New York, would pick up more business from institutional investors that want to stay with ETFs tied to better-known MSCI indexes, analysts and consultants say.

Vanguard officials announced Oct. 2 that in January they will begin to use indexes from two providers, the University of Chicago Booth School of Business' Center for Research in Security Prices and the FTSE Group, London, dropping those provided by New York-based MSCI.

The change means that BlackRock — the biggest ETF provider through its iShares unit — will no longer have to compete with third-ranked Valley Forge, Pa.-based Vanguard on key ETFs that use the same indexes, such as both firms' emerging markets ETFs.

The iShares MSCI Emerging Markets Index Fund, BlackRock's biggest ETF, has been losing market share to the Vanguard MSCI Emerging Markets ETF because Vanguard charges significantly lower fees. The Vanguard ETF surpassed the iShares ETF in assets in January 2011, becoming the third largest ETF in the U.S.

The Vanguard ETF, with an expense ratio of 0.2%, had $67.1 billion in assets as of Sept. 30; BlackRock's iShares emerging markets fund, with an expense ratio of 0.67%, had $36.8 billion.

BlackRock CEO Laurence D. Fink said last month that price cuts were coming for the company's large, liquid core-type ETFs that have lower-priced competition. But analysts say the price cuts might not happen now that Vanguard is changing indexes and will no longer compete with BlackRock on key ETFs that use the same MSCI indexes.

Institutional investors tied to the MSCI indexes, the dominant indexes used to track international equities, probably will switch back to iShares regardless of the higher fees, said Doug Sipkin, an analyst with Susquehanna Financial Group LLC, New York. “The MSCI indexes are the gold standard for institutional investors,” he said.

Given, that, he said BlackRock may reassess it's planned price cuts. “Why would BlackRock lower the fees? It makes it no sense,” said Mr. Sipkin.

ETF consultant James Pacetti, who works for S-Network, an index consulting firm and provider in New York, agreed. Vanguard will lose some institutional ETF and retail investors to BlackRock because those investors will want to stay with the more popular MSCI indexes.

“I think the cork bottles were popping in Larry Fink's office when BlackRock executives heard the Vanguard news,” Mr. Pacetti said.

BlackRock spokeswoman Christine Hudacko said the company would have no comment on whether it planned to go ahead with the ETF fee cuts.

But BlackRock has moved quickly since the Vanguard announcement, said Christopher Shutler, an analyst with William Blair & Co. LLC, Chicago. “ BlackRock has already started marketing the differences between the MSCI and FTSE indexes to its institutional investors, so they're clearly looking at this as a market-share opportunity,” he said.

It is unclear just how much of Vanguard's $271 billion in ETF assets comes from institutional investors. A Pensions & Investments analysis of data from Deutsche Bank and FactSet shows that approximately 40% of the assets in the Vanguard MSCI Emerging Markets ETF comes from institutional investors.

Saving on fees

Joel Dickinson, a senior ETF strategist at Vanguard, said the company switched index providers to save hundreds of millions of dollars in fees for investors.

“We are trying to do what is in the best interest of investors. Our philosophy has always been what people want is emerging markets exposure, not particularly a branded emerging markets index,” Mr. Dickinson said.

But he conceded that Vanguard could some lose institutional business from investors tied to the MSCI indexes. “We are not naive enough to say there aren't institutional constraints,” Mr. Dickinson said. “We certainly saw the possibility that there might be some short-term movement of assets.”

Certainly the biggest loser, at least over the short term, is MSCI, the New York-based index provider.

Losing Vanguard will cost MSCI about $24 million of its $140 million in annualized revenue, and a hit of about 6% to adjusted earnings before interest, taxes, depreciation and amortization, said William Blair's Mr. Shutler.

BlackRock (BLK) now becomes MSCI's main ETF licensing customer, accounting for 17% of adjusted EBITDA, he said.

With the Vanguard revenue disappearing, Susquehanna's Mr. Sipkin said BlackRock might be able to get concessions on its ETF licensing fees. He said BlackRock's iShares unit will account for close to 80% of MSCI's ETF licensing revenue after the Vanguard move.

BlackRock pays MSCI $60 million to $70 million in ETF licensing fees, Mr. Sipkin estimated. He said he believes BlackRock could lower fees to the $30 million to $40 million range over time.

BlackRock's Ms. Hudacko would not comment on whether the company would be seeking pricing concessions.

But BlackRock did reaffirm its commitment to MSCI indexes.

“The company plans to deepen our partnership with MSCI to help deliver the highest-quality products and portfolio construction to our clients,” said BlackRock's Mark Wiedman, global head of iShares, in a statement.

MSCI CEO Henry Fernandez in the past has touted the index provider's long-term contracts with ETF providers such as Vanguard as a sign of the company's strength.

But in a conference call with analysts following the Vanguard announcement, he conceded that ETF providers are not bound to pay the licensing fees if they switch assets to another index.

He said assets “may not be as sticky as we all thought.”

MSCI could also be facing increased competition from index provider FTSE.

Officials at FTSE — which won the contract from Vanguard for six international ETF indexes, including the emerging markets ETF — said they are pushing to expand FTSE's U.S. business.

Jonathan Horton, president of FTSE Americas, New York, called Vanguard's move to FTSE “transformational.” The Vanguard agreement will more than triple ETF assets under management that use FTSE indexes, to about $93.8 billion from the current $26 billion.The Center for Research in Security Pricing, which landed the contract to license its indexes for 16 of Vanguard's domestic ETFs — its first commercial ETF venture — also plans to market its indexes to other providers once they are implemented at Vanguard in January.

But Mr. Barclay said CRSP does not plan a full-scale licensing effort because its primary mission is educational, providing research indexes and databases.

This article originally appeared in the October 15, 2012 print issue as, "Vanguard ETF index switch could help BlackRock".