As new entrants in the ETF market challenge the established leaders by cutting fund fees, margins have slid, meaning that the cost of licensing indices from external providers like MSCI, FTSE Russell and S&P Dow Jones is chipping away an increasing percentage of profits.
In view of this, more and more ETF providers are becoming attracted to the idea of developing bespoke indices and saving on licence fees.
However, while the methodology of an index may be developed in-house, much of the data required to calculate it still has to be imported from elsewhere. The sources of the input data depend on the asset class and the market structure underlying the index.
For example, in equity markets price data come from an exchange or a regulated market venue and are usually provided by a market data aggregator, while in over-the-counter (OTC) markets prices usually come directly from market participants.
How often an index is calculated is primarily a reflection of how the underlying market trades. Many equity indices are calculated in real time, instantaneously reflecting changes in their constituents’ stock exchange prices. However, many more specialist equity indices and most fixed-income indices are usually calculated only once a day, often at the close of trading.
Indices also require periodic reviews and reconstitution. They are rebalanced in a way that the index designer feels appropriate to best represent the underlying market. Some rebalance once a year, some quarterly, and some much more frequently, each time reflecting the changes to the constituents that result from stock exchange listings and delistings, corporate actions, bond maturities, coupon payments and new issues.
According to Mark Raes, head of product management, Canada, at BMO Global Asset Management, external index providers may levy higher costs, but there is work involved: “They will deliver value through rebalancing, corporate actions, education and thought leadership, to name but a few advantages,” he says.
BMO issues both index-based and non-indexed ETFs in Canada, as well as index-based ETFs in the UK and Hong Kong.
On the other hand, Raes says, “The biggest pro for self-indexing would be an adaptive methodology where you can establish the rules based on your own criteria.”
In April this year, Fidelity launched its first two self-indexed ETFs in Europe, the Fidelity US Quality Income ETF and Fidelity Global Quality Income ETF. Both are so-called smart beta products, leveraging the company’s experience in active management and applying it to a new area.
For each ETF, the methodology starts with a broad universe of stocks that represent the target market. This is then screened to identify quality stocks with good profitability and strong cash flows. Finally, the highest-yielding stocks are selected for inclusion in the final portfolio.
The motivation behind a self-indexing approach was not to reduce the cost of creating the indices, says the firm, but to differentiate Fidelity from the rest of the market by incorporating the firm’s experience of managing actively-managed portfolios within an index-tracking product.
However, while Fidelity has designed the methodology for the indices, they are calculated and distributed by external index provider Standard & Poor’s Dow Jones on a daily basis.
The use of a third party means that, in additional to the costs incurred internally for developing the index, any self-indexed ETF may face other administrative costs, as well as computing costs, operational redundancy costs, data licensing costs, data validation costs, costs for regulatory compliance and the costs of non-price input data.
Christian Bahr, head of market data and analytics at SIX Swiss Exchange, says: “Traditional index providers have access to economies of scale, while self-indexing ETF providers may find that set-up costs mean their indices are actually more expensive to run, especially in the early years.”
And the resources needed are not confined to money, he says.
“You have to create a methodology for the index, and also show what happens if, for example, there’s a company takeover or spin-off,” says Bahr. “For that, you need experienced people with index knowledge, but there’s not a large pool of people you can just hire. You have to know them already or find people who are working for the competition.”
From the investor’s point of view, probably a more pressing issue with self-indexation is the potential for conflicts of interest.
“The risk investors have is if the self-indexing firm has conflicts that could cause the investor to not always be the beneficiary,” says Richard Redding, CEO of the US-based Index Industry Association, the lobby group for index providers.
“The right question is, do they properly spend enough to mitigate those risks? Are they spending enough to ensure data accuracy, contingency back-up facilities and systems, and the mitigation of conflicts?”
Redding says that an independent index administrator neither trades the component securities of the index, nor creates or distributes the product the investor uses.
“This allows for checks and balances along the value chain,” he says. “An independent index administrator’s goal is to best represent the underlying market and the administrator does not have an interest in whether the market goes up or down.”
BMO Global’s Raes argues that the relative importance of cost and the scope for conflicts of interest can depend on the make-up of the index.
He says: “The more generic the exposure, the more cost matters to institutional investors relative to other factors. Governance becomes a bigger consideration when the exposure is more differentiated and niche.”
SIX Swiss Exchange’s Bahr says: “There is a risk that elements from financial products, such as trading costs or currency exchange costs, are embedded in the index calculation formula. Sometimes, self-indexers include costs such as licence fees, trading costs and currency exchange costs within the index, when they should be included in total expense ratios of the financial products instead.”
For instance, he says that a short strategy index might include the cost of borrowing money to buy derivatives to create the short exposure.
“Only by excluding these costs from an index can the performance of different managers be properly compared,” says Bahr. “At SIX Swiss Exchange, we calculate our indices without embedding any trading costs.”
Fidelity believes that the potential conflicts of interest involved in self-indexing can be addressed by means of appropriate standards of governance.
“There is no input from the investment managers into the constituents of the index or its calculation,” says Nick King, head of ETFs at Fidelity International. “The entity which is involved in index design is physically and legally separate from the entity which does the investment management.”
Second, Fidelity’s index committee, made up of employees with specialised knowledge, meets regularly to review the index rules and check the modelling is still relevant as the market evolves, the firm says.
The Index Association’s Rick Redding points out the general importance of integrity in indexing.
“The index business is a reputation business because if there are material inaccuracies, conflicts of interests, and operational issues, investors will not use the underlying index or products, regardless of price,” says Redding.
Following the LIBOR scandal, in 2013 the International Organisation of Securities Commissions (IOSCO), the coordinating body for global securities regulators, published a set of benchmark principles, covering governance, benchmark quality and accountability.
Separately, a new European Benchmark Regulation will come into effect from 1 January 2018. The regulation creates the role of a benchmark administrator, held to strict new standards and with permanent and effective oversight of a firm’s benchmarks.
Fidelity’s King says: “I think the new legislation will be very effective in ensuring indices are appropriately constructed. They will need to be administered by a regulated entity which has to demonstrate that appropriate governance is in place.”
But Redding sees the new rules not only improving transparency but also shaping the market in favour of the incumbent index firms.
He says: “The upcoming European benchmark regulation, the IOSCO benchmark principles, and regulatory changes to the market after the financial crisis have increased and will continue to increase compliance costs. These will likely be more difficult for smaller, newer entrants to afford.”
But overall, he says index creation and administration is a highly competitive business where investors continue to benefit because licensing costs, as well as the costs of the investment products based on indices, continue to decline.
Redding also sees increased diversity in the roles which independent index providers will play.
He says: “Some indices will be created by asset managers, as we have seen for creating ETFs, while some will be created by the independent index administrators for creating funds, exchange- traded products, and OTC products.”
He adds: “Self-indexers typically do not license their indices to others, while independent indexers do. We are seeing and are likely to see more partnerships between asset managers using their intellectual property to create an index, while outsourcing the calculation and administration to independent administrators.”
He observes that asset managers are also putting their active strategies in rules-based indices to take advantage of the distribution potential of the ETF market.
“These asset managers are realising that the administration piece is not a core business for them, and may outsource it, so the hybrid of the two will likely become a bigger piece of the market.”
King says: “My view is that self-indexed products will not dominate the market any time soon. Market capitalisation-weighted indices such as the FTSE 100 or S&P 500 will always be very important because these are indices that both institutional and retail investors relate to.”
But he continues: “However, self-indexation will still be important for products like smart beta. There will be more entrants in the market this year, and a number of those will look to take this approach in order to leverage their heritage.”
“Self-indexing will become more prevalent as products continue to launch with a differentiated strategy,” says Raes. “It will become increasingly difficult to launch ‘me-too’ products as we continue to see a demand for innovative solutions which address the challenges facing investors.”
He adds: “At the same time, I expect the core solutions to continue being indexed. In certain cases, institutional investors face risk from tracking error to their mandates, and following those same indices in an ETF removes that risk.”
And he concludes: “Overall, we see value in having independent index providers. While the growth of the market will lead to increased competition and more pressure to innovate, core ETFs will continue to benefit from partnering with established index providers.”
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