ETFs Put Index Firms On Notice

April 02, 2013

The rapidly expanding ETF juggernaut may slowly be turning the staid world of indexing inside out.

Amid the fee wars, ETF issuers are pressed between a rock and a hard place in terms of where to cut expenses. One place issuers have looked to cut expenses is on licensing fees paid to index providers.

For many issuers, this means moving from high-cost, well-branded index providers to other, cheaper options.

Vanguard made quite a splash in the ETF world last year when it did exactly that: The low-cost fund company announced a transition away from some MSCI-based indexes to lower-cost alternatives from FTSE and CRSP.

No big deal?

On the day Vanguard made its announcement, MSCI’s shares tumbled nearly 27 percent. Six months later—a period during which the S&P 500 Index rallied 20 percent—MSCI’s stock is still selling at a 7 percent discount to its pre-Vanguard-announcement levels.

If you think this is no big deal, you’re wrong.

ETF issuers, such as Vanguard, pay index providers, like MSCI, a fee to license indexes. Fee structures can vary but, at the end of the day, bigger index fees mean a smaller piece of the pie for you.

Indexes are critically important because an index’s methodology dictates the selection and weighting of your investment portfolio. Creating a solid, investable index is not easy—there’s a lot to consider—but it’s not rocket science either.

One of the realizations of the low-cost movement is this: As retail investing in ETFs continues to gain steam, investors don’t want to pay for—and certainly don’t need—the brand-name index anymore.

To take it a step further—the importance of issuer brands themselves is beginning to supersede the importance of index brands. That’s pretty much the card Vanguard played.

Let’s reflect on how the ETF world has come full circle: As ETFs escalated in popularity, they were initially designed to provide low-cost exposure to an index—with the index being the critical element. The ETF itself was—and still is—just a conduit to the index.

Turning Tide

From my experience talking with large portfolio managers and individual investors, it appears investors are increasingly selecting their ETFs based on either the exposure provided and liquidity offered or, alternatively, based on the brand name of the ETF.

For example, some investors are familiar with and trust the Vanguard name, so they choose Vanguard ETFs regardless of other options. Additionally, in the past it has been difficult to independently assess true exposure, so it was safer and logical to stick to well-known names, like MSCI.

Now, many independent firms, such as IndexUniverse, offer research that presents exposure intricacies in an easily digestible format. And as ETF issuers expand existing reputations or build new reputable brand names, like WisdomTree, investors are looking less and less to index providers.

Large brand-name index providers, like MSCI, are getting pinched in the middle, as other efficient, cost-effective index providers, such as CRSP, are seizing the moment and soliciting the business of large issuers like Vanguard.

CRSP is a great example of the indexing alternatives that are cropping up.

The Center for Research in Security Prices (CRSP), which is part of the Booth School of Business at the University of Chicago, is newer to the world of investable indexing—indexing isn’t rocket science—and they have developed indexes that efficiently represent specific segments of the market.

So, what’s the point of all of this?

 

 

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