Fees for domestic stock index funds are falling, even as the surging bull market brings increased business to indexers.
Fees are almost so low that U.S. stock index fund money managers aren't getting paid for the risks they take, said Ronald O'Hanley, chief operating officer, Mellon Global Asset Management, Boston.
"Typically, pension funds are paying two basis points on accounts up to $100 million and sometimes nothing after that, with the expectation that money will be made on securities lending. That is how most indexers are making it pay," he said.
Mr. O'Hanley believes fees are hitting bottom, however.
It's also possible the indexing business could start to work like the custody business: "Those services are routinely priced at zero. The custodians get the assets to lend and make their revenues from that," he said.
The subject of sliding prices is a sensitive one. Some of the major indexers interviewed for this article confirmed fees are getting sliced, but declined to cite specifics. And executives at Barclays Global Investors, San Francisco, the nation's largest indexer with $284.1 billion in indexed assets, declined any comment.
Indexing fees have been trending down over the past three years.
"But if prices go so low that we feel we're not getting paid for the risk we're taking, we won't bid on a job," Mr. O'Hanley said.
Who pays what
Tom Loeb, chairman and chief executive officer at Mellon Capital Management, San Francisco, a subsidiary of Mellon Global, estimated straight domestic stock indexing fees have fallen 20% to 30% in the last four years, while enhanced and active fees have remained the same.
He cited figures from a new study by Callan Associates, San Francisco, that found published fees on passively managed accounts of $50 million or so range from seven to 14 basis points, declining as accounts get larger. Accounts over $100 million would pay from six to 10 basis points, while accounts of a billion dollars or more would be around 2.5 basis points, Mr. Loeb said.
These averages don't take securities lending into account, which could reduce the fees by as much as one basis point.
Enhanced indexed fees average 30 basis points on $50 million accounts, he said.
Of course, most fees are negotiated, and tend to be much lower than published fees.
Spokesmen at several large public pension funds said they pay only one or two basis points, excluding securities lending.
Securities lending an advantage
But non-bank indexers like Alliance Capital Management, New York, aren't in a position to give up the management fee in exchange for securities lending.
"That's a disadvantage for us," said Joseph Potter, the senior vice president who runs Alliance's passive group.
Still, Alliance makes money on indexing because overhead is low, he said. "We don't need an arsenal of analysts, or the infrastructure required for active management. We rely on computer systems and electronic communication."
Mr. Potter and other major indexers said they expect the enhanced indexing part of the business to catch on more than it has so far, which in turn will generate higher fees.
The standard fee for Alliance's 5-year-old enhanced index product, which uses S&P futures, is seven basis points plus 25% of any upside over the Standard & Poor's 500 Stock Index.
Fees on straight indexing also start at seven basis points but drop quickly, depending on size of assets, Mr. Potter said.
"They have been really dropping as assets have grown," he observed. In the last three years, Alliance's enhanced S&P 500 strategy has been attracting new clients, growing from $200 million in 1994 to $700 million now. By contrast, its pure indexing business has remained at $20 billion during that time.
Frank Salerno, chief investment officer for Bankers Trust Co., New York, and Mellon's Mr. Loeb also said they are seeing more interest in enhanced indexing.
Pure indexing performs well
But several pension fund executives and consultants contend enhanced indexing hasn't taken off because straight indexes have performed so well.
The $33.7 billion Washington State Investment Board, Olympia, is one example. Trustees decided in May to terminate three enhanced index managers along with three active managers and to index the entire domestic equity portion - $14.5 billion. Previously, 82% of domestic equity assets was passively managed.
"Over the last few years only one of the active managers beat the index and only one of the enhanced indexers matched the index. The other enhanced index managers performed below the index," said Christopher Ailman, chief investment officer.
Meanwhile the S&P 500 is up 24.07% through Sept.10 and fees for pure indexing are dramatically lower, Mr. Ailman pointed out.
"We believe we will do better by running a passively managed domestic equity portfolio and seeking higher returns in other asset classes."
Around 49%, or $2.45 billion, of Washington's $5.4 billion international equity component is indexed.
Barclays Global has been Washington's index manager for several years, but a search is on for a new manager.
Lower fees expected
"Now that we're 100% indexed, we expect our fees will go even lower," Mr. Ailman said. "The issue for us is the net income we get from securities lending, because that covers our fee. These can vary from a 50-50 arrangement like ours to one where the client gets 70%, the bank gets 30%"
The $27.5 billion Oregon Public Employes' Retirement Fund, Salem, also recently increased the passively managed portion of its $10 billion domestic equity allocation, raising it to 50% from 30% in the last month.
"It's been very difficult for active managers in a robust market, which influenced our decision," said Jay Fewel, senior equities investment officer. "Most of the money is in the S&P 500 index, but we have invested a small portion in a value index.
Sources say Oregon is paying about one basis point, before securities lending.
The $9.2 billion Los Angeles Fire & Police Pension System also has been paying around one basis point for the $1.2 billion portion of its domestic equity assets that is indexed, said one of the investment officers. The figure does not include securities lending.
Surveys show the same trend.
Talk, not action
"There's a lot of talk about enhanced indexing, but not much action," said John Webster, partner at Greenwich Associates, Greenwich, Conn.
In its annual survey of 2,300 pension funds last year, the firm found the majority use the S&P 500 as the benchmark for passive equity management. The survey also showed pension funds have raised their passive U.S. equity allocation to 33% from about 28%.
"Most of the managers surveyed expect to stay at that level over the next three years. The indexers have been offering consistent returns at low fees over time, outperforming active managers, and pensions want consistency," Mr. Webster said.
Bob Jaeger, chief investment officer at Evaluation Associates, Norwalk, Conn. said: "Pension plans have gotten very aggressive in driving fees down in the last couple of years after firing active managers. Indexers want the business, so they take it. It could be a loss leader for other businesses for them."
But big indexers insist indexing remains profitable, and that automation has helped reduce costs.
Bankers Trust's Mr. Salerno predicted fees for straight domestic equity indexing will continue to collapse, but he expects increased business in enhanced indexing and quantitatively driven actively managed portfolios will pick up some of the slack.