Rise of Indexes Threatens to Eclipse Their Creators

Index providers have won big in the great migration from high-priced active management to low-cost index funds. But their fortunes are set to turn.

The same trend that brought index providers to prominence is now coming for their profits: Investors are in no mood to pay fees. Investors plowed a net $2.5 trillion into mutual funds and ETFs that charge 0.2 percent a year or less from 2007 to 2016, according to Broadridge, which tracks data from 80,000 funds globally. That’s more than twice what they invested in all other funds combined.

Money managers are listening. The asset-weighted average expense ratio for actively managed equity mutual funds declined to 0.8 percent a year in 2016 from 0.95 percent in 2007. Index funds have lowered fees, too. The asset-weighted average expense ratio declined to 0.11 percent a year from 0.18 percent during the same period. 

While managers have made peace with pay cuts, index providers are raking in a growing bounty by licensing their products. London Stock Exchange Group Plc’s FTSE Russell — one of the “Big Three” index providers along with S&P Global Inc. and MSCI Inc. — generated 135 million pounds in index-related fees in the third quarter. That’s a 59 percent increase from the first quarter of 2015, the earliest quarter for which numbers are available.

S&P and MSCI did even better. They collected $190 million and $185 million from their index businesses in the third quarter, an increase of 33 percent and 38 percent, respectively, since the first quarter of 2015.

No one wants to disturb a moneymaker. Echoing active managers, index providers are puffing up their investing prowess and playing down fees. The chief executive officer of S&P Dow Jones Indices, Alex Matturri, told Bloomberg News in August that “if assets are growing and your revenue is growing, that’s the right strategy.” He added that questions about cost are “overblown.”

Mark Makepeace, the head of FTSE Russell, said that “If all you do is compete on fees, you’ve lost the battle of ideas and, first and foremost, we compete on ideas and providing the best product. The fees come after.”

But how special are the Big Three’s ideas? Their U.S. large-cap indexes, for example, follow different methodologies. An index committee selects the stocks in the S&P 500, while the Russell 1000 uses a rules-based approach to select twice as many. The MSCI USA Index is also rules-based and includes 632 stocks as of November.

And yet the three indexes have performed nearly identically. The S&P 500 has returned 12 percent annually from 1979 through November, including dividends — the longest period available for all three indexes. Over the same period, the Russell 1000 and the MSCI USA Index returned 12 percent and 11.8 percent, respectively. 

The results are the same any way you slice them. The average rolling 10-year annual return for all three indexes was 10.9 percent during the period. And all three indexes had identical risk-adjusted returns, with a Sharpe Ratio of 0.5. (The Sharpe Ratio measures how well investors are paid for volatility, with a higher ratio indicating more compensation.)

Which raises the question: Why should index funds license third-party indexes? The results would presumably be similar if they created their own. And with investors demanding ever-lower fees, money saved on licensing fees can be passed on to investors. (Full disclosure: Bloomberg LP, the parent of Bloomberg Gadfly, owns an indexing business that competes with S&P, MSCI and FTSE Russell.)

In fact, index funds are doing just that. Charles Schwab Investment Management sought approval last summer for a stock ETF that would track a proprietary index of the largest 1,000 U.S. stocks and charge as little as zero to 0.02 percent a year. In October, State Street Global Advisors replaced FTSE Russell with market-cap indexes of its own for three ETFs and reduced fees.

Index funds are also getting in the smart beta game. BlackRock Inc.’s iShares rolled out two smart beta fixed-income funds last summer that track BlackRock indexes. And the Vanguard Group announced last week that it will offer a suite of low-cost smart beta funds to U.S. investors next year that won’t track indexes.

This is just the beginning. Index providers should heed the experience of active managers. It’s their turn to feel the squeeze.

Source: Bloomberg Gadfly, https://bloom.bg/2BhIBhk