With increasing pressure on ETF providers to offer lower total expense ratios (TERs) on their products, cost control is an important part of their business. One of the largest costs can be payments to index providers such as MSCI, S&P, Russell and FTSE and these are a big burden for low-cost products.
Index licensing costs for ETFs
It is difficult to obtain the exact charges for licensing an index from providers as the information is not publicly available and is included in the overall TER of the product. However, the largest ETF globally is the SPDR S&P 500 ETF in the US and as this is a trust the information is disclosed in its prospectus. For 2017 the licence fee was $69,123,020, based on the actual assets under management in this ETF this equates to around a 3bps fee for the index licence.
These well-known index providers are able to charge relatively high fees to ETF providers for using and tracking their brand-name indices, these costs are then passed on to investors via the TER.
Self-indexing pros and cons
It is no surprise that ETF providers are looking, once again, at self-indexing as this can reduce the overall cost of the passive product, but by how much when everything is taken into consideration?
There are advantages and disadvantages to self-indexing.
There would be lower costs because the provider wouldn’t be paying an index provider, flexibility in the benchmark methodology rather than using an off-the-shelf version and the ability to control the index rebalance date.
Disadvantages would be that many investors prefer a well-known index provider and may decide not to invest in a self-indexing passive – particularly institutional investors who use benchmarks to compare against their portfolio performances.
Does self-indexing really save on costs?
Other disadvantages to self-indexing are that it can be expensive still for a provider to do this who might need infrastructure upgrades to cope with the self-indexing in terms of research and analysis and extra staffing costs. Plus there would still be costs in paying an independent agent to calculate the index. Also creating their own index rather than picking one off the shelf may lead to longer fund launch times.
Self-indexing can be very costly to build your own research team and maintain an index unit and unless a company has enough scale to absorb those costs, it makes no sense for ETF providers to self-index for the sake of trying to lower costs to investors.
Cutting out the middle man sounds like a promising road to cost savings, but the creation and ongoing maintenance of an index within a separate business division requires additional resources, so the provider would have to have sufficient scale to make it cost effective.
ETF providers using self-indexing
So far in Europe, self-indexing ETFs tend to be towards smart beta passives like the product ranges from WisdomTree and Fidelity rather than the standard developed market cap indices.
It is more likely that ETF providers would use self-indexing for factor-based methodologies, such as value or quality, rather than for the standard indices tracking developed markets where the underlying shares are selected based on the size of their market capitalisation.
However, these indices are generally not fully in-house creations.
The ETF providers design the rules and methodology for the indices but they are independently calculated and disseminated to the market by the likes of S&P and State Street as agents in order to meet the various regulations by European Securities and Markets Authority (Esma). Although this is a cheaper option than using the large index providers, the ETF providers (and therefore the investors) are still paying for the index calculation.
European-domiciled passive ETFs using self-indexing indices
| Passive Product | Assets Under Management | ETF launch date |
| WisdomTree Japan Equity Ucits ETF | $246m | November 2015 |
| WisdomTree Europe Equity Ucits ETF | $155m | October 2014 |
| Fidelity US Quality Income Ucits ETF | $127m | March 2017 |
| WisdomTree Europe SmallCap Dividend Ucits ETF | $86m | October 2014 |
| Fidelity Global Quality Income Ucits ETF | $53m | March 2017 |
Invesco has launched US-domiciled products using their own created indices, but as yet there has been no movement towards this in their European domiciled products.
Another provider, L&G, will be working with Solactive who will act as the index calculation agent while L&G will provide the methodology and percentage weight changes.
Ultimately there still seems to be demand from ETF investors for the branded indexes, like MSCI and S&P and some of the larger ETF providers like iShares, SPDR and X-trackers in Europe do not currently have any plans to use self-indexing in the near future.
