Index Firms Matter More Than You Think

April 15, 2013

ETF issuers have made a lot of high-profile moves in the index space lately. That doesn’t mean those moves are the best decisions for investors.

My colleague, Spencer, recently wrote about ETF issuers challenging the dominance of index firms through switches in affiliation and even self-indexing. The point is well taken, as it marks a significant shift in the industry. However, the assumption that investors will benefit across the board is something I have to challenge a bit.

One point I challenge is the idea that self-indexing by ETF issuers is a net benefit to investors. Often we hear about the massive cost savings that investors can receive through lower operating costs, but that argument completely disregards the inherent conflict of interests in such a strategy.

Call me old-fashioned, but I’m a firm believer in everyone playing their roles within the ETF space. As I mentioned in my previous blog, when ETF issuers get involved in other areas of the business—whether it’s trading or indexing—investors will likely find their interests come secondary in business decisions. Simply put, self-indexing allows for ETF issuers to make compromises that may not fall in line with best practices within the index space.

Index construction is also something to be taken very seriously. Firms like MSCI, FTSE and Standard & Poor’s have years of experience in the selection, weighting and construction of indexes. They also help in creating the standard by which ETF issuers aim to reach in the creation of their funds. Arguing that self-indexing leads to lower costs is akin to saying that football games refereed by the players leads to cheaper game tickets. You may save a few dollars, but you’re watching a different type of game altogether.

And the “lower costs” argument doesn’t hold up in a number of areas. Take the "Equity: Developed Ex- US Total Market" segment for ETFs as an example. Currently there are over 14 ETFs in the space. In the segment, the WisdomTree DEFA ETF (NYSEArca: DWM), a fund that tracks a WisdomTree index, comes in with an expense ratio of 48 bps—4 times the cost of its competitor, the Vanguard MSCI EAFE ETF (NYSEArca: VEA).

Although the tide is turning with regard to self-indexing firms taking up a significant portion of assets, many institutional firms are still benchmarked against MSCI indexes, as Spencer notes in his original blog. That’s exactly what drives home my point—institutional-level money managers appreciate the value and consistency in the measurement of index providers as opposed to simply investing in funds with low expense ratios—something that’s not even guaranteed in the self-indexing space.

I’m sure some investors have warmed up to the idea of seeing a vertical integration in the ETF space. However, it’s quite clear there’s a true value in having role players within the space as well.



At the time this article was written, the author held no positions in the securities mentioned. Contact Ugo Egbunike at [email protected].

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