While the rise of passives has put a squeeze on asset management fees, the index market is dominated by a few companies exerting their pricing power. However, the MSCI annual report for 2017 highlights the growing number of asset managers creating proprietary indexes, which they use to manage funds or as the basis of ETFs, structured products or OTC derivatives, as a risk to its business.
In Q3 2018, MSCI reported $765.5bn in ETF assets were linked to its indices, up 19.3% from the same period in 2017, driving a 30.4% increase in asset-based fees, while S&P Dow Jones reported average ETF AUM associated with the company’s indices increased 23% year-on-year to $1.5trn.
At FTSE Russell, a subsidiary of the London Stock Exchange Group, $663bn was benchmarked against its indices in Q3 2018, up 16% on the previous year. In contrast, Schroders, one of the largest active fund houses in the UK, saw AUM within its asset management division increase 4.5% over the same period.
Index providers hit ETF returns
A Cerulli report published in November says the pricing power the index providers enjoy ultimately results in lower returns for investors. Institutional investors are therefore driving demand for more cost-effective solutions, the report says.
Intermediaries are in favour too. 7IM senior investment manager Peter Sleep says the licensing fees that make index providers profitable are a large component of an ETF’s cost. “Alternative benchmarks correlate closely with branded indexes but they are much cheaper.”
The details of index licensing fees are commercially sensitive, although due to its trust structure the SPDR S&P 500 ETF revealed in its prospectus for 2017 that it paid $69,123,020 to S&P Dow Jones, approximately 0.03% of AUM.
Additionally, the 2017 MSCI annual report shows Blackrock contributed 11.5% to its revenues for the year, equivalent to $146.5m. The annual report highlighted the risk to MSCI of clients developing in-house products, pointing out a number of its clients, including Blackrock, had already received regulatory clearance to create indexes as the basis for ETF products.
Index deals with ETF issuers can range from licensing the rights of one index to a full suite.
“Asset managers have started to build self-indices intended to be more flexible than the indices provided by third parties,” says André Schnurrenberger, managing director for Europe at Cerulli. “The self-indices are more in line with the specific and tailored exposure requested by investors and, importantly, do not have additional third-party costs.”
Self-indexing has been an area of interest in the ETF industry for the last couple of years but few companies are moving aggressively in that direction, says JP Morgan Asset Management head of international ETFs Bryon Lake.
Creating proprietary indices in-house is not as simple as it might seem with regulatory requirements and best practice aiming to keep product providers and index providers separate.
Lake says: “You could see an argument that [self-indexing] could potentially bring some additional flexibility and then there’s what I would call regulatory challenges, where within index regulation in Europe you have to abide by certain rules. We’re currently evaluating what that would look like and weighing that up.”
In January 2018, EU benchmark regulation came into force with the aim of minimising conflicts of interest in benchmark-setting processes while also ensuring benchmarks are robust and reliable.
Conflicts of interest between ETF and index providers could range from front running index changes or tampering with an ETF’s net asset value.
As such, asset managers work with index providers and calculation agents to create self-branded indices.
Franklin Templeton Investments, for example, worked with MSCI and FTSE Russell to create the methodology for its LibertyQ smart beta ETF Ucits range. Fidelity International offers four Ucits ETFs which are all based on the Fidelity Quality Income Index developed with S&P Dow Jones Indices and made up of large and mid-capitalisation dividend paying companies from developed countries that exhibit quality fundamental characteristics.
Smart beta and environmental, social and governance (ESG) ETFs are obvious areas for growth in self-indexing, according to Cerulli.
Wisdomtree’s business model is based around proprietary indices, but since the acquisition of ETFS it has a number of products that track third-party indices. Currently, 62.7% of AUM is held in self-indexing funds.
Christopher Gannatti, its head of research in Europe, says the most widely-followed indices may be the avenues for producing the best investment returns. The lack of license fee and the ability to engage directly with the end clients about index methodology are among the benefits of self-indexing, says Gannatti.
JPMAM does not currently offer self-indexing ETFs and its does not have any special relationship with the JP Morgan investment bank when it comes to employing its indices. “We’re contractually engaged with them in the exact same way as some of our competitors are engaged with them,” says Lake.