Index providers are getting active

Equity index providers, riding high on investor moves into passive and global investments, are also getting more active.

Each of the four largest index providers — FTSE International Ltd., MSCI Inc., Russell Investments and S&P Dow Jones Indices LLC — has created new rules-based ways to select stocks that aim to outperform traditional market-cap-weighted indexes, thereby pitting them against active money managers.

The evolution is changing the companies' primary function as providers of performance measurement tools to providers of investment insight and strategies for investing, often via third-party products such as exchange-traded funds.

Not that traditional business is bad. FTSE's compound annual growth rate in revenue was 21% for the five years ended Dec. 31, while annual income grew an average 24% in the period. MSCI's operating revenue doubled in the two years ended Dec. 31, while net income more than doubled. Sales at S&P Indices rose 18% in 2011, and Standard & Poor's traces a 29% compound annual growth rate of its index business back to 1994. A joint venture forged in July saw the combination of S&P's index unit with Dow Jones Indexes to create the world's largest index business.

But index providers are gearing up, acquiring companies (or being acquired) to take advantage of cross-selling opportunities. In addition to the S&P/Dow Jones deal, the London Stock Exchange Group PLC last December acquired the half it didn't already own of FTSE from Pearson PLC, and MSCI acquired RiskMetrics Group and Measurisk in 2010.

The index provider industry faces pressure from providers of ETFs, which pay licensing fees to index companies. The rise of cost-cruncher Vanguard Group Inc. in ETFs has put pressure on such funds that track traditional indexes, while BlackRock is threatening to create its own indexes for its iShares ETFs.

“It's a very interesting time for the index business. There's a transition from being a benchmark data provider to more of an investment solutions business,” said Michael Larsen, director and head of affiliate relations at Research Affiliates LLC, Newport Beach, Calif. About $60 billion tracks RAFI indexes, which weight securities on fundamental factors as opposed to market capitalization.

“It's no longer just, here's indexing, but here's indexing and here's how to use it in your portfolio. That will become a differentiator in the marketplace,” said Benjamin F. Phillips, partner at Casey, Quirk & Associates LLC, Darien, Conn., a consultant to money managers. Those firms content to provide only the investment tools “will find themselves less able to defend their fee proposition,” Mr. Phillips said.

The move to providing solutions and new complex strategies boosts the level of expertise required for providers, in explaining how new index strategies work and how they might fit into a client's portfolio, sources said.

“The winners will be the ones that become trusted advisers on helping plans understand these solutions,” Mr. Larsen said. But building that expertise is “not an easy feat.”

“It requires more of an investment background to sell these products,” said Rolf Agather, managing director of global research and innovation at Russell Indexes, a unit of Russell Investments, Seattle. Russell has added a senior research director role and sales roles specializing in pension funds, endowments and foundations and in structured products in the past year.

Some growth prospects are unique to each firm. For example FTSE, a subsidiary of London Stock Exchange Group PLC, is targeting the U.S. market, where it is a much smaller player than its global competitors. “For us, the opportunity lies both in the move to global equity portfolios and also to thematic and strategy indexes,” said Nick Teunon, chief financial officer at FTSE, London.

But the major battlegrounds for future revenues are in global and emerging markets as well as in other asset classes; in the licensing fees paid by investment products like ETFs; and in the move into smart beta, or rules-based indexes and strategies that are not market-cap weighted.

On May 2, Russell teamed up with Barclays Capital Inc., a dominant player in fixed-income indexes, to create liability-driven investment indexes. Two days later, MSCI announced a separate partnership with Barclays Capital to create a family of environmental, social and governance bond indexes.

“Our approach has been to look for segments of the market to play on our distribution strength or where the market isn't sewn up” by investment bank providers, said Alexander J. Matturri, CEO of S&P Dow Jones Indices, New York.

Mr. Matturri thinks the pricing scandal over the London interbank offered rate might highlight conflicts of interest at investment banks that calculate prices of bond indexes and sell products based on them. That would open the door to competition in providing bond indexes.

“LIBOR is a kind of index,” Mr. Matturri said. “The business models in the fixed-income (index) world might have to change.”

Across their businesses, index providers see much more revenue growth potential in the fees paid to license their indexes for investment, especially given the increasing interest in smart-beta strategies.

“The hot topic is how ETFs are evolving, and index providers play a very big part in how they evolve,” said Jennifer Huang, director and research analyst at UBS AG in New York.

Smart beta is creating new ways to invest in passive, transparent vehicles, while still making active bets — that is, taking investment paths that diverge from market-cap-weighted approaches. While still a small part of their businesses, index providers and market observers agree this area is growing and will boost indexers' bottom lines.

“People are recognizing the value of these indexes, and they're starting to move money in a meaningful way,” Research Affiliates' Mr. Larsen said.

However, Henry Fernandez, chairman and CEO of MSCI, New York, tempered expectations that smart beta will make a sweeping impact on his business in the next few years. “Everything we do has a long burn,” he said. “It takes a while to pick up. Therefore the vast majority of the revenues of our company, today and tomorrow, comes from the existing businesses and the existing customers.”

But he added that smart beta is “critically important today because some client needs are evolving to smart beta (and because) it is extremely important today for thought leadership (and) to plant the seeds for future growth of the company. We are determined to be a very large provider in that space.”

While client demand is pulling index providers toward new smart-beta indexes, these companies are also being pushed in that direction, as cost pressures threaten to squeeze their traditional businesses, sources said.

“Low-cost ETFs have seen a disproportionate amount of net inflows over the past few years, for both traditional domestic equity ETFs and global/emerging markets ETFs. However, we find that industry management fees have remained roughly stable, thanks to launches of more complex ETFs that command higher management fees (and where fee pressure is less severe),” according to a June investor report by UBS that Ms. Huang wrote.

According to the report, volatility-based ETFs and other factor-based ETFs represent a combined 0.8% of total U.S.-listed ETF assets under management, but account for a total of 4% of net inflows in so far in 2012.

While he recognizes it as a key growth area, Russell's Mr. Agather said “it's really not clear” how big a role smart-beta strategies might play in Russell's business. In the past year or so, Russell has created new LDI, factor-based and “investment discipline” index families, while expanding its offerings in its defensive and dynamic indexes to global markets.