Continued pressure to lower exchange-traded fund (ETF) fees has forced issuers to look at where to make cuts. Index providers could be the latest casualty.
It comes amid the rise of self-indexing and an increasingly agnostic attitude from ETF providers towards index brands. Talk of going it alone has increased in recent weeks, after the Financial Times reported ETF providers were floating the idea of creating their own market indices.
Competition in the index sector has been fierce. There has been consolidation among the large players, the most recent of which was last month, when the London Stock Exchange (LSE) acquired Citigroup’s bond indexing business for $685 million (£537 million).
Despite this activity, the cost of index licences remains unclear. The Financial Times reported in its article that, last year, revenues for the three main providers increased between 7% and 17%. According to a source, who wished to remain anonymous, one index provider makes a 71% margin on fees.
‘With high index fees, it’s difficult for ETF providers to reduce ETF fees,’ said Steffen Scheuble, chief executive of index provider Solactive.
Self-indexing helps keep costs lower. It is not a new concept and has been happening in the US and the smart beta space. In Europe, firms such as WisdomTree offer the service.
Allan Lane, managing partner at Twenty20 Investments, said there was much merit to self-indexing and it comes into its own when creating niche indices. This rise of self-indexing has created an increasingly agnostic attitude to index brand.
‘Brand name of the ETF provider plays a big part,’ said Lane. ‘Brand name of an index, if it isn’t one of the main benchmarks, is largely irrelevant so long as the index does what it intends.’
Scheuble agreed index brand was not as important anymore.
ETF providers argue investors are now focusing on index methodology. ‘Investors focus more on the robustness of the index methodology, and whether it delivers the exposure they are looking for,’ said Chanchal Samadder, head of UK and Ireland institutional ETF sales at Lyxor Asset Management.
‘In the case of market cap weighted indices, most indices that are focused on the same geography and segment are highly correlated, delivering almost identical returns.’
Index fees vary depending on the index provider. In 2012 Vanguard Asset Management switched the index provider on 22 of its funds from MSCI to FTSE to cut costs.
S&P Dow Jones Indices (SPDJI) only charges an ETF issuer a percentage of its fees. ‘Our interests are aligned with ETF issuers,’ said John Davies, managing director and global head of exchange-traded products (ETPs) at SPDJI. ‘As assets grow, we benefit. But as they decrease our fees reduce.’
There are limitations with self-indexing. Lane said it was simple to do in the equity space, but much harder in the fixed income world.
Peter Sleep, senior portfolio manager at Seven Investment Management, said he would be particularly wary of non-equity indexes where pricing sources were not transparent. ‘We have seen examples of financial institutions failing to manage conflicts of interest in the Libor scandal and gold fixing, [which are] both indexes of a sort,’ he said. ‘Is it appropriate for a bond market maker or bond portfolio manager to also produce indexes? There is a potential conflict of interest.’
Self-indexing is not allowed in all markets. Regulators in some Latin American countries take a dim view of self-indexing.
‘There are reasons things haven’t changed yet and that is the size and power of big index providers,’ said Scheuble. ‘Certain asset owners, such as pension funds, are often linked to well-established indices and the pressure isn’t coming from them, it’s from those buying the product.’