The last 10 years have seen a transformation in the index business, and the line between benchmark provider and ETF issuer is looking increasingly blurred.
[This article previously appeared on our sister site, IndexUniverse.eu.]
The relationship between index and exchange-traded product (ETP) providers was once clear-cut, with each having a separate and distinct role to play. But product innovation, cost pressures and regulatory changes have led to a crossover in functions in some cases. This has made it harder to distinguish who's doing what in the indexing business. The types of company involved in providing index-based investments and the key components necessary to piece together an ETP have also changed dramatically. Given this rapid evolution, how should observers piece together the indexing jigsaw?
The fund management business is built around core portfolio management and associated trading functions. As well as offering traditional, actively managed funds, many firms now also issue and distribute index-tracking exchange-traded funds (ETFs). Index funds have been around since the mid 1970s, when Vanguard launched the Vanguard 500 Index fund, tracking the S&P 500. The development of ETFs in the 1990s added another strand to the index-based investment approach. Now, index mutual funds and ETFs collectively represent some 15 percent of the net assets of investment companies, the dominant form of mutual (pooled) fund in the US.
US Investment Company Net Assets At End 2010
|US investment company total net assets||$13.1 trillion|
|Index tracker mutual funds||$1 trillion|
|Exchange-traded funds||$992 billion|
To most investors the stock market benchmark index providers are the face of the index industry. Strongly associated with domestic stock exchanges, the likes of S&P and FTSE have developed well-known brands and are synonymous with the markets they index.
Independent index providers have grown significantly over the last decade and most now cover a range of different asset classes. Index platforms are data- and technology-intensive, but independent providers have been able to develop custom index and in-sourcing businesses. Both these areas of activity have generated important new revenue streams.
Much in the news of late, investment bank "delta-one" desks are involved in various types of index-related trading, ranging from the provision of total return swaps on indices or stock "baskets", to market making in ETPs. Many banks are also active in issuing ETPs. The first ETNs were issued by an investment bank, while in Europe several investment banks have also developed in-house fund structuring teams. On the index front, the provision of fixed income indices is dominated by the investment banks' index groups, usually housed within the firms' research divisions. Investment banks also constitute the major providers of strategy indices.
The success of the ETF market has spurred the creation of a new breed of independent ETP providers, for example ETF Securities, Source and Ossiam in Europe. These new entrants typically partner with investment banks to provide index-based products.
Piecing Together The Product
At the heart of every ETP is an investment methodology—typically (but, as we'll see, not always) embedded within the index that the product tracks. At its simplest this may be a market benchmark tracking the returns of a specific market or market segment. ETPs can also be constructed around investment themes and strategies, which are normally embedded in an index. The investment methodology (index) forms the main piece of intellectual property in the ETP business.
A robust and accurate index calculation and publishing platform is now a prerequisite for an index to be eligible for use in an ETP. The majority of exchanges require real-time index levels for ETFs and notes, and index closing levels need to be available near to the underlying market's closing time.
As well as calculating and publishing real-time and official (end-of-day) net asset values (NAVs), an ETP issuer needs to link to various execution venues (so-called "wrap" platforms and brokers), and to the exchanges on which products are listed.
In Europe there are two primary methods by which ETPs deliver index returns. Physical replication is the original method for ETFs, whereby a portfolio of instruments is held in the fund to match those held by the index. This portfolio can either match the index stock for stock, or be based on a sampling methodology. With synthetic replication, the economic exposure to the fund's underlying index is obtained via a swap, an over-the-counter derivative written by a third party, typically an investment bank.