A robust and lucrative corner of the exchange-traded fund business is drawing fresh scrutiny and new questions that cut to the core of the ETF value proposition: Do indexes matter?
Regulators, asset managers and investors in the U.S. are showing by their words and actions that they are reconsidering the value of independent index providers such as S&P Dow Jones Indices, a majority-owned business of S&P Global; the FTSE Russell unit of the London Stock Exchange Group; and MSCI Inc.
For example, on Sept. 18, State Street Global Advisors introduced five ETFs tracking country indexes maintained by German index firm Solactive. Four of the ETFs previously were tracking MSCI indexes and carried 0.30% expense ratios. The new products cost 0.14%.
In August, BlackRock (BLK) Inc. (BLK)'s iShares unit swapped indexes and cut expense ratios on four fixed-income ETFs. Affecting nearly $20 billion in assets, the four ETFs moved to indexes maintained by Intercontinental Exchange and Bank of America Merrill Lynch from Bloomberg Barclays indexes.
An earlier but more significant index transition occurred when Vanguard Group Inc. jumped to the Center for Research in Security Prices and FTSE Russell from MSCI for 22 funds in the fall of 2012, sending MSCI shares down nearly 30% on the news.
The CRSP is now the backbone for 10.5% of U.S.-listed indexed equity ETFs, up from 8.3% in 2014, according to research firm XTF Inc, a unit of London Stock Exchange Group.
Comparatively, S&P Dow Jones Indices supports 42% of the $2.9 trillion indexed-equity exchange-traded product market, with 18% to FTSE Russell and 17% to MSCI. Collectively, the market share of the top three index firms has been consistent for five years.
An emerging challenge to those dominant index providers also is coming from asset managers themselves.
The phenomenon known as "self-indexing" was first championed by WisdomTree Investments, which manages $41 billion in ETFs, primarily on its own equity indexes focusing on earnings and dividends.
Other ETF providers that have found success with affiliated index providers include Goldman Sachs Asset Management, State Street Global Advisors, Northern Trust, Victory Capital Management Inc. and J.P. Morgan Asset Management (JPM).
Each firm has more than $3 billion in self-indexed equity ETF assets under management, according to XTF.
Arrival of no-fee funds
The power of an affiliated index provider was recently unleashed for retail investors when Fidelity Investments launched four no-fee index mutual funds on its own indexes, calculated by S&P Dow Jones Indices.
"Self-indexing also allows us more flexibility in our pricing structure and was important in being able to offer these funds with zero expense ratios," a spokeswoman for Fidelity said.
Jeremy Schwartz, head of research for WisdomTree in New York, said: "Owning the intellectual property backing the indexes is a better business model. To compete in this industry, you can't just offer beta, which we've been saying for years would be eventually priced at zero. Now, we're seeing it."
And while third-party index publishers dominate the fund and benchmarking landscape, the U.S. Securities and Exchange Commission is "scratching at" some critical issues in its proposed ETF rule, said Rick Redding, CEO of the Index Industry Association in New York.
Released in late June, the commission asked: Should the proposed rule include requirements relating to index-based ETFs with an affiliated index provider? If so, what requirements and why? For example, should ETFs with affiliated index providers be required to adopt additional policies and procedures designed to further limit information-sharing between portfolio management staff and index management staff? How should we define "index provider" for these purposes?
In a March address at an Investment Company Institute conference, Dalia Blass, director of the SEC's division of investment management, wondered if an affiliated index provider could be considered an investment adviser. To what extent might the index provider take "significant input from the fund's sponsor or board regarding the creation, composition or rebalancing of that index?" she asked. "Clearly this is a facts-and-circumstances analysis without a bright line."
Yet, the European Union is in the middle of implementing that bright line with Benchmarks Regulation that defines disclosure and controls for benchmark providers. The regulation, largely a response to the manipulation of the London interbank offered rate and euro interbank offered rate, went into effect in January with a two-year phase-in.
The Index Industry Association's Mr. Redding, whose organization represents the major index firms as well other index publishers including Bloomberg, Cboe Global Markets, IHS Markit, Nasdaq and others, said the European benchmark regulation begs the question of a check on conflicts of interest for U.S. investment products and strategies.
"Self-indexing has focused people's minds more than ever before," he said. "Is there any economic intuition behind the benchmark other than back-tested data?"
One of the ongoing strengths of the largest index providers is their extensive consultation process, Mr. Redding said.
"Our methodologies are developed in consultation with clients and external advisers," said Rolf Agather, managing director of North American research for FTSE Russell in Seattle. "There's transparency throughout and a collaborative process when developing custom indexes for asset owners and asset managers."
Such an extensive process also has afforded the index providers healthy operating margins. S&P Global recently reported 67% operating profit in its index business for the six months ended June 30. MSCI reported 73% adjusted EBITDA margins over the same period and the information services business of LSEG, which includes FTSE Russell, reported a 54% operating profit "before non-underlying items."