Index Wars: The effect of increased competition on ETF providers, and institutional investors

As long as investors continually look for new and better ways to invest in, track or beat the market, index providers will continually be challenged to find ways to create better, more robust benchmarks to meet customer expectations. The demand on index providers today is greater than it's ever been. Top indexers are expected to do more and more, and as a result changes in the industry are necessary to respond to increased investor demands. This has greatly increased competition among indexers and that competition has had a direct effect on exchange-traded funds providers, pension funds and other institutional investors who are focused on passive investing.

In the past, almost anyone with a computer could create an index. They were relatively simple and didn't require a lot of functionality. Today, however, index providers are expected to create, calculate and disseminate indexes rapidly with the ability to perform years of back-testing. Customers ranging from ETF providers to institutional investors are looking for full service indexers with sophisticated databases that have the capabilities and flexibility to respond to their growing needs.

Customer demands and priorities are shifting like we've never seen. The index licensing cost component of total expense ratios has continued to decline in financial products over the last several years and ETF providers are increasingly willing to re-evaluate their current benchmarks in search for the best value available. In the early days of ETFs, the index was a key part of a buyer's purchase decision. Companies such as S&P sold products and people bought ETFs based in large part to the overall brand of the index provider.

While having a strong index brand is still important to investors, more and more investors are instead focusing on the brand of the product provider (e.g., Vanguard, PowerShares, etc.). Today, the top three ETF/ETP providers — IShares, SPDR ETFs and Vanguard — account for 69.6% of Global ETF/ETP assets, while the remaining providers each have less than 4% market share, according to ETFGI.

Since the brand of the index provider is now only a part of what drives the investment decision, ETP providers have the flexibility to choose among multiple index providers offering nearly identical benchmarks. The increased competition is driving down costs, thus reducing expense ratios. Sophisticated index investors are getting smarter and more willing to look at a broader array of offerings as ETF providers share these cost saving measures with their customers.

With increased competition comes the natural commoditization of products and certain index segments. Global equities are a great example. Twenty years ago, it was actually quite complicated to find a global equities ETP product; however, it is much easier today because every major indexer offers a very similar suite of benchmarks. In the same way, the market has come to expect a consistent set of standards for representing different market sectors so the diversions among index providers are much narrower than they used to be. Twenty years ago, the differences between the offerings of the various index providers were fairly wide. Today, the differences are minimal, making it easier to step from one provider to another, and ultimately reducing the cost of the product.

Of course there are certain exceptions where index providers differentiate themselves. There are some flagship indexes such as the S&P 500 and the NASDAQ-100 where commoditization has not taken hold. There are also niche indexes, such as a sector family or specific industry-focused indexes like the NASDAQ Biotechnology index, where a few indexers have a distinct foothold on the industry.

Much of the focus on fees is thought to be on the shoulders of ETF providers, but they are only part of the ecosystem. Pension consultants, who recommend specific benchmarks to their clients, are also starting to weigh in on index licensing costs. Up until recently, consultants were not as cognizant of how much the people downstream were paying for data. For the asset owners and their managers, this was a hidden cost. Now, they are realizing that this data cost is a factor in overall investment performance. Previously, consultants' primary focus was on their clients' asset allocation, risk tolerance and risk profile. More often than not, they would then default to the brand name indexes they were accustomed to using.

Today these indexes are receiving more scrutiny based on their pricing. Consultants need to truly understand that every decision matters and which benchmark they choose can make a huge difference in cost. They should be asking themselves the following questions:

• Are my benchmarks truly reflective of the underlying components of that asset class?
• Are they trackable?
• Does the provider have a good track record and the ability to track the indexes it offers?
• Can I access the data?
• Is it reliable?
• What does it cost?

As the index world changes, pension funds and other asset owners are going to demand more from their consultants when they walk in the door with their recommendations.

The movement to reduce costs is a big change for the indexing industry and one that will likely accelerate over time. The entire industry — ETF providers, asset owners, pension consultants — is becoming more aware of the costs associated with various indexes and is more willing to look at alternatives to reduce these costs. As more investors become aware of the fees they are paying, the pressure will mount.

Not everyone in the indexing industry is going to be able to keep up. We are already beginning to see consolidation and in the next five to ten years the field will likely be further reduced, with only six or seven large indexers and a few niche players remaining in the game. The midsize indexers will more than likely disappear due to the effects of price competition. In the end, the main beneficiary from this competition will be the investor since these cost savings are passed on in the form of lower fees and expense ratios.

John L. Jacobs is executive vice president of NASDAQ OMX Global Indexes.