Large index providers such as MSCI and FTSE Russell are charging exchange traded fund (ETF) providers and asset managers significant fees, which are squeezing their margins and could be keeping prices higher for investors.
There has been ferocious price competition in the ETF market in recent years, with providers forced to slash fees on popular funds such as those that track the FTSE 100 and S&P 500 indices. And at the same time as ETF providers' margins are squeezed, the index providers they rely on have become ever more powerful, enabling them to command tens of millions of pounds in fees per year.
Market indices are used in every area of the financial system and the companies which devise them charge hefty licence fees to anyone referencing index data, or the companies and sectors within their indices. The strength of brands such as the FTSE 100 or S&P 500 means that large providers such as MSCI and FTSE have almost no competition in areas where ETF issuers face the most pressure, so index providers can make highly lucrative returns.
In 2016 MSCI generated more than half of its revenue from its indexing business, a sum of $613.6m (£479.47m) - an increase of almost 10 per cent on the previous year. BlackRock, which owns ETF provider iShares, was alone responsible for 9.4 per cent of MSCI's operating revenue in 2016.
MSCI runs well known global and regional indices including MSCI World and MSCI Emerging Markets. FTSE Russell has a strong UK brand with indices such as the FTSE 100 and FTSE All-Share, while S&P dominates in the US market.
"The index licence fee for a FTSE 100 ETF can easily make up between 3 and 4 basis points of an ETF's assets under management (AUM)," says one source within an ETF company.
Other ETF providers said that an S&P 500 licence fee could account for as much as 5 basis points out of an ETF's ongoing charge, which might not amount to much more than 5 basis points in total.
Meanwhile many ETF fees have come down to single digits. For example, Source S&P 500 UCITS ETF (SPXS) costs just 0.05 per cent and iShares Core S&P 500 UCITS ETF (CSPX) 0.07 per cent. The cheapest FTSE 100 tracker, iShares Core FTSE 100 UCITS ETF (ISF), now costs just 0.07 per cent. And commentators say that ETF companies are, in some cases, are barely scraping a margin on ETFs tracking major indices, forcing them to make up revenue elsewhere.
"The leading index providers benefit from their quasi-monopolistic positions in the indexing market," says Simon Klein, head of passive distribution, EMEA at Deutsche Asset Management. "We would like to see more competition to put pressure on licencing fees, as lower fees would benefit our clients."
The profits of the main index companies, meanwhile, are getting larger. For example, MSCI's profit on its indexing business is set to surpass 70 per cent in 2017, and S&P Dow Jones, whose S&P 500 index is the most followed stock market, made an operating profit margin of 64 per cent on its index business last year and in 2015, an increase on 2014.
The power of the index giants is partly due to the power of their brands, which for many investors have become synonymous with the markets themselves.
"When you think of the UK market, you think of the FTSE 100 and when you think of the US you think of the S&P 500," says Peter Sleep, portfolio manager at Seven Investment Management.
Adam Laird, northern Europe head of ETF strategy at Lyxor, adds: "The index market in equities is dominated by just a few players - MSCI, FTSE, S&P and Stoxx. Although there is some new blood challenging the behemoths, in most cases the familiarity of those brands means that investors and asset managers are very unlikely to use other products."
The index providers are getting bigger. FTSE, which is owned by the London Stock Exchange (LSE), merged with US index provider Russell Investments in 2014 in a $2.7bn deal. The volume of assets benchmarked against FTSE indices has ballooned from $381bn in 2015 to $452bn in 2016.
S&P and Dow Jones merged in 2012, and assets worth $7.5 trillion track the S&P 500 index alone. And ETFs with assets of more than $10 trillion are benchmarked against MSCI's indices.
"We've seen a lot of consolidation in the last two or three years among the main index providers," says Hortense Bioy, director of passive funds reseach, Europe at Morningstar. "Before, there were maybe six players, but now you have just three or four. It has led to an oligopoly which is not good for prices."
Index providers' charges are based on assets under management, but as fees are negotiated with asset managers the largest players can get better deals. "MSCI don't have a price list - it's really just how far they have you over a barrel," says one asset manager.
Howie Li, chief executive of CANVAS, a part of ETF Securities, adds: "In the past, index contracts used to have an element of fixed as well as variable fees. Fixed fees can be a high cost for product providers so they end up being passed onto investors. We know of some contracts where index providers wouldn't do business unless you signed up to a seven digit annual bill - but we never went down that road."
The number of providers offering ETFs tracking popular indices might fall as smaller companies can no longer compete on core products. "It's going to be harder and harder for new entrants to be able to offer large-cap equity products at prices that are competitive," says Mr Laird.
But the biggest players such as iShares and Vanguard can afford to accept smaller margins in some business areas while generating revenue elsewhere.
"Indexing is a scale business," says Ms Bioy. "Margins are one thing but in absolute terms you can accept a lower margin if you have a higher volume. If you do not have a high volume, you are out of business and smaller ETF providers will have to differentiate themselves. In this business you can either win by lowering the cost of your ETFs or by offering ETFs that others don't."
Some ETFs, meanwhile, have been loaning out increased amounts of their stock in recent years for less collateral and less liquid assets, to generate cash. In 2015 BlackRock scrapped a 50 per cent limit on securities lending for its European domiciled funds and cut the level of collateral required from borrowers of its stock, while also loosening its restrictions on the type of collateral accepted.
As a result, its securities lending revenue increased by $66m between 2015 and 2016 to $579m "primarily reflecting an increase in average balances of securities on loan and higher spreads", according to BlackRock. Vanguard started securities lending for the first time last year with 16 of its London-listed ETFs.
Nizam Hamid, head of strategy in Europe at ETF provider WisdomTree, says: "Securities lending benefits the end investors and ETF issuers because they are able to keep a portion of the revenue. For example, with a fund that has assets of £23bn that could be a meaningful sum."
Making the switch
An increasing number of ETF providers are switching their funds to track different indices to get a better deal, sometimes resulting in price cuts for investors. For example, last year Lyxor switched Lyxor FTSE Actuaries UK Gilts Inflation-Linked UCITS ETF (GILI) and Lyxor FTSE Actuaries UK Gilts UCITS ETF (GILS) from tracking Market iBoxx indices to FTSE Actuaries indices. The deal was accompanied by a significant chop in Lyxor FTSE Actuaries UK Gilt's ongoing charge from 0.18 per cent and Lyxor FTSE Actuaries UK Gilts Inflation-Linked's from 0.22 per cent, to 0.07 per cent in both cases, making these the cheapest gilt and inflation-linked gilt ETFs listed in London.
In 2012 Vanguard switched 22 ETFs which tracked MSCI indices, to FTSE indices with the UK funds and the Chicago Centre for Research in Security Prices (CRSP) indices with the US funds to lower costs, after securing lower-rate, long-term deals with the latter two providers. For example, Vanguard FTSE Emerging Markets UCITS ETF (VDEM) now has a lower ongoing charge of 0.25 per cent.
The deal resulted in a $24.8m rolling loss of revenue for to MSCI. At the time Vanguard accounted for $122.1bn of the average value of assets linked to MSCI equity indices - more than a third.
However, evidence of providers using smaller index providers for major markets remains limited. Although new providers have entered the field in recent years few have been successful. One that has is BATS Europe, which has become Europe's largest stock exchange by value traded. It launched 18 UK stock indices in June 2016 to take on FTSE, and earlier this month it launched a further 18, such as Bats Eurozone 50 to compete with EuroStoxx 50 and Bats Europe All Companies to compete with Stoxx Europe 600.
Like the FTSE 100, Bats 100 tracks the UK's largest 100 companies but Bats says its own index is more transparent and far cheaper to use. The company publishes its index methodology and constituents - unlike rivals. And ETF companies and managers pay just one flat fee for a licence, displayed in an online price list. The benchmarks are also free for private investors and the media to use, with data provided in real time.
Mark Hemsley, chief executive officer of Bats Europe, says: "There is a consistency across our indices and how they're approached across Europe [unlike the patchwork of large providers who dominate in different regions, using different methodologies to each other]. And our aggregation of indices is better too, for example, how you construct a 350 out of 100 and the 250 - it all works as building blocks."
However, no UK-listed ETFs track Bats indices, although the company is being used by large wealth managers.
Wealth managers ditch index giants ETF companies are not the only ones affected by the might of the index providers. Wealth managers are growing increasingly frustrated with the iron grip of the index giants and some have started to reject even the most powerful players. Last year Charles Stanley stopped using FTSE for its investment platform and wealth management business when that index provider increased prices by 120 per cent in one year. Charles Stanley signed a deal with Bats costing under £150,000 for five years, which is understood to have been one quarter of the cost of FTSE's quote. Magnus Wheatley, managing director of Charles Stanley Direct, says FTSE's fees were "Eye-watering. They put the costs up by over 100 per cent in a year and have no recognition whatsoever that we, as a direct to consumer platform, are in a cut-throat pricing business and simply cannot afford data feeds for which they increase their charges on a whim because they think they have a monopoly," he says. Alliance Trust Savings, AJ Bell, Charles Stanley Direct, Hargreaves Lansdown, Rathbones, Selftrade, and TD Direct Investing now use Bats data. Another wealth management company said it had considered using data company FactSet instead of MSCI, as it was "practically giving the data away for free". But client demand and access to MSCI's risk forecasting system, Barra, meant they stuck with MSCI. |
Some commentators say that most ETF providers still do not have the clout to risk scrapping the FTSE or MSCI names from a product, although others argue that the increased might of ETF giants like iShares and Vanguard should give them more power to shift the brand obsession with the major index providers.
"In the early days people knew the index but not the ETF issuer, but I don't think that is the case now," says Mr Hamid.
However, investors need to change their attitudes. "At the moment FTSE and MSCI really do have a great time of it but I think there could come a time when people say enough is enough," says Ms Bioy. "But it is dependent on investors being comfortable with using other index brands too."
Mr Klein adds: "As competition increases in coming years I think it is inevitable that the big index providers will have to either alter their business models, reduce fees or do both."
Knock-on effect
Because of tight margins on their most popular ETFs, some providers are offering increasingly large ranges of smart beta or alternatively weighted ETFs, for which they can command higher fees from investors and pay less to index providers.
ETF companies often use smaller index providers for niche products and even collaborate with them on new indices, which they can earn more from and, in some cases, retain intellectual property rights on the licence. This does not result in lower prices for investors but can lead to more innovation in under-served areas, for example fixed income.
"We sometimes work with index providers to create bespoke indices in niche areas, such as fixed income smart beta, for example," says Mr Klein. "This makes sense as we can add our intellectual capital to the smart beta strategy, and also means we can potentially use more niche index providers that will be more flexible on fee arrangements."
He says that companies including German index house Solactive are more willing to offer flat fees and can be more flexible about the indices themselves. Deutsche Asset Management has collaborated with Solactive on db x-trackers Mittelstand & MidCap Germany UCITS ETF (XDGM).
But Deutsche Asset Management also works with the large index houses on indices, for example, it recently launched X-trackers iBoxx USD Emerging Sovereigns Quality Weighted UCITS ETF (XQUA), which aims to track a range of higher-quality emerging markets bonds.
"We work with Solactive on a number of ETFs and with another group called Indxx," says Mr Li. "They charge very fair fees and you can ask them to construct you a basic index very easily. If you just want an index of the top 500 companies by market cap, that information is publicly available. People will increasingly be asking why you need to pay a big brand index provider to do that for you - there is certainly an argument not to."
Solactive provides the underlying indices for two ETF Securities funds: ETFS US Energy Infrastructure MLP GO UCITS ETF (MLPI) and ROBO Global Robotics And Automation GO UCITS ETF (ROBO).
But large providers can charge significantly less for non-branded custom indices. For example, the cost of a non-branded custom-made S&P index was just $10,000 per year for a licence with a set-up fee of $25,000 - significantly less than an S&P branded index.
WisdomTree has gone down a different route altogether. The company is the only ETF provider in the UK to devise and license its own indices in-house, although it uses an external agent for index calculation. It only offers funds tracking alternatively weighted indices such as WisdomTree UK Equity Income UCITS ETF (WUKD) and WisdomTree Europe SmallCap Dividend UCITS ETF (DFE).
"We wanted to deliver something unique," says Mr Hamid. "Index providers don't do exclusive deals anymore, so you could easily be going up against another ETF issuer with greater margin power than you tracking the same index. Plain vanilla indices are an incredibly saturated space."
This strategy has enabled WisdomTree to avoid having to compete on fee cuts - as well as cutting indexing costs. "Everything we do is smart beta and about adding value, so we are not fighting on a single basis point type of fee structure," adds Mr Hamid.
