Self-Indexing: Investor Friend Or Foe?

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September 25, 2012
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If BlackRock gets the green light to self-index, the world of ETFs may never be the same.

 

Self-indexing in the ETF industry is hardly a new phenomenon. In fact, many ETF providers such as WisdomTree and IndexIQ have successfully built entire business models that rely solely on in-house index creation.

But up until recently self-indexing had been pretty much confined to niche strategies, and that’s a state of affairs that will no longer prevail if iShares, the world’s biggest ETF company, jumps into the self-indexing game.

In the summer of 2011, BlackRock—iShares’ parent company—filed paperwork with U.S. regulators seeking permission to self-index its exchange-traded funds. iShares offers a vast roster of funds that tap into just about every segment of the market.

Having iShares possibly join the likes of WisdomTree and IndexIQ as companies that create benchmarks for their own funds would certainly shake up the status quo for big and influential index providers such as S&P Dow Jones Indices, MSCI, Russell and FTSE, to name a few.

“No one had a beef with WisdomTree and IndexIQ,” said Kathleen Moriarty, an attorney with Katten Muchin Rosenman LLP in New York who had a hand in writing some of the early self-indexing petitions submitted to the Securities and Exchange Commission. “They were indexing firms that believed in their indexes and wanted to create products around those indexes,” Moriarty said.

“What interests me is that it seems like people are all of a sudden flipping out, and I think it’s because BlackRock is deciding to do self-indexing. BlackRock was not in the index game originally, so it has a different profile than the original two firms,” Moriarty said.

BlackRock looking to join the ranks of self-indexing ETF providers has indeed triggered a wave of controversy, with some saying that the do-it-yourself approach to indexing ETFs does nothing but open the door to conflicts of interest and mismanagement, with the questionable benefit of lower cost promises to investors.

Controversy notwithstanding, a series of interviews IndexUniverse did with industry heavyweights pointed to one conclusion, namely that whether self-indexing is a good trend for investors is really in the eyes of the beholder.

Devil's In The Details

For one, companies like WisdomTree and IndexIQ have successfully dodged much of criticism directed at the self-indexing movement because what they serve up is anything but plain-vanilla funds.

In other words, they’re not reinventing the S&P 500, and nor do they want to.

In fact, one head of a self-indexing firm went as far as to say that if he were ever to launch an S&P 500-like fund, he would be giving S&P Dow Jones Indices a call.

Instead, the strategies they have put into ETF wrappers are off-the-beaten path enough to arguably make in-house index methodology creation and management a necessity. That’s because third-party index providers might not be prepared to meet these companies’ needs, so the argument goes.

“For us, it’s really all about quality control and oversight of our products,” Adam Patti, the chief executive officer of Rye Brook, N.Y.-based IndexIQ said in a telephone interview.

In IndexIQ’s case, the company creates the methodology, runs the models, but delegates the actual index calculation to a third party, or S&P Dow Jones.

That delegation of calculation is something that goes unnoticed by many, S&P Dow Jones Indices' Alex Matturri said. Indeed, the giant index provider has many layers of offerings, some of which include calculating indexes that don’t carry the S&P Dow name brand, as is the case for IndexIQ benchmarks.

“The decision to self-index is less related to cost, but more related to quality control,” Patti said. “It’s very costly to build your own research team and maintain an index unit.” he said, arguing that unless a company has enough scale to absorb those costs, it makes no sense for ETF providers to self-index for the sake of lowering costs to investors.

The Low-Cost Imperative

 

“Before ETFs, when you were an index provider—like an S&P or a Russell—you sold your intellectual property, or you licensed your intellectual property for a flat fee, so when Vanguard had their Vanguard 500 fund, they paid S&P a flat fee of $100,000 or something,” Jonathan Steinberg, WisdomTree’s chief executive officer, said in a recent interview.

 

It wasn’t until ETFs that the index providers changed their business model and started to charge on growth and assets, thus participating in the growth of the funds” he said.

That “participation” in the growth of these funds is what’s making licensing of third-party indexes a costly proposition as ETFs grow in size. By extension, rising costs have become one of the arguments self-indexers use to justify their decision to bypass the independent index providers.

 

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