The rising cost of benchmarking

Institutional and individual investors today are paying substantially lower investment management fees than when Morningstar opened its doors more than 30 years ago. Why? More investment options, greater access to information, and demand for transparency from asset owners, regulators, media and firms like ours. The dramatic rise of lower-cost passive investments — including exchange-traded funds and passive open-end mutual funds — which now capture more than a third of the U.S. market, is evidence of this trend.

With the advent of the Department of Labor's fiduciary rule — which says financial advisers must make recommendations in the best interests of their clients to address conflicts of interest in retirement advice — investment expenses should continue to decline.

One cost, however, that's moving in the opposite direction, is the fee charged for benchmarking investments and related licensing costs paid by asset managers, custodians, wealth managers and software platforms, and to a lesser extent consultants and asset owners. Ultimately, these fees get passed on to individuals down the line.

The ability to measure and compare relative investment performance is extremely important. But only a handful of index providers control the vast majority of the market, and those providers are using their power to dramatically increase fees. In fact, 73% of U.S. mutual fund assets are benchmarked against one of just three index providers, according to the Financial Times. Each brand-name provider has indexes that have become synonymous with a particular asset class — U.S. large-capitalization stocks, global equities and emerging markets are good examples.

Many investment managers tell us that fees they pay for benchmark data have doubled or tripled in the past five years, with little justification for the increase. I've heard several anecdotes that benchmarking data is one of their top-five data expenses. We're concerned that the market relies on a small number of index providers charging top dollar for this critical information.

It's difficult to overstate the importance of benchmarks in the investment process. They give investors the ability to manage risk, understand the drivers of return and cost in their portfolios, and compare investment performance. Proper benchmarking is a powerful tool for increasing an investor's chances for success.

Benchmarks are meant to explicitly represent the performance of the underlying markets and asset classes. I believe market cap-weighted equity indexes are virtually identical and track similar securities. They should be priced accordingly, but they're not.

So we're embarking on an initiative, called the Morningstar Open Indexes Project and embracing the concept of open source, a powerful model that has created meaningful change in the software industry. Applying a similar concept to benchmark indexes can have equally powerful results. Because we believe benchmarking costs shouldn't be so high, we're taking the first step by offering Morningstar's own global equity indexes to the industry for benchmarking at no cost.

As part of this project, Morningstar has formed an indexes advisory council, composed of 25 leading financial firms so far, including Ariel Investments, Eaton Vance Management, and Guggenheim Investments.

This group is coming together to effect change for the overall industry because we all believe that investment performance measurement should be reliable, transparent, accessible — and affordable. We surveyed our advisory council members and they agree that the exponential price increase of benchmark data is an important issue and burdensome cost. Nearly half of the members told us that relative to other investment components, benchmark licensing costs have risen dramatically over the past two years. But the majority said they have not changed benchmark providers because of switching costs and other barriers.

It's our hope that by highlighting this issue, we can offer the industry a new path to lowering costs at the firm level and, ultimately, reducing charges to institutional and individual investors.

Just as mounting pressure has influenced the investment management industry to change its cost structure, reducing benchmarking fees could be another step in that evolution.

Our research shows that lower fees are closely associated with better investor outcomes. Earlier this year, Russel Kinnel, our director of manager research, examined the predictive power of fees on performance measures of many kinds — including total returns, load-adjusted returns, and risk-adjusted portfolio ratings. Using expense ratios to make investment choices helped performance in every asset class from 2010 to 2015. As the findings show, fees are invariably a strong and dependable predictor of future investor success.

The investment management industry has come around to this way of thinking. In the five years ended Dec. 31, 2015, 63% of mutual fund share classes and exchange traded products in the Morningstar universe reduced their expense ratios. Of course, that's primarily a function of where today's investors — increasingly with more information and more choice — are willing to put their dollars. Through year-end 2015, 95% of all flows over the past 10 years have gone into funds in the lowest-cost quintile. Over that same period, the asset-weighted expense ratio declined 27%.

I believe this downward trend will continue. By shining a light on fees, we've seen flows move toward lower cost, better performing investment options. Now we're pointing a spotlight on benchmarking fees.

The Open Indexes Project has the potential to change the index landscape and, in the long term, contribute to lower costs for institutional and individual investors.

Join us.

Joe Mansueto is chairman, CEO and founder of Morningstar Inc., Chicago.