A report from the TABB Group offers a thorough assessment of the business of indexes.
We in the index industry are a pretty insular bunch. We go to the same conferences; read the same Web sites; study the same data. So sometimes it takes an entirely fresh perspective to gain some real insights into our business.
TABB Group Senior Analyst Adam Sussman recently authored an exhaustive report on the index industry from the perspective of an outside observer. "Performance Anxiety: A Buy-Side Study On Benchmarks And The Investment Process," published December 2007, is an excellent summation of where the industry currently stands and provides a look into where it's headed. Much of the research was gathered through talking to 38 industry participants—mainly investment managers or pension plans in the U.S. and Europe that oversee or manage $2.32 trillion. Among the topics it hits on are the evolution of the business of index provision and its future, how pension funds use indexes, and the roles of exchange-traded funds (ETFs) and hedge funds. I'm not even going to attempt to summarize all 38 pages, but I am going to point out a few highlights. (By the way, we're following up with a Q&A-style interview with Adam Sussman within the next couple of weeks.)
The report cites a number of interesting and useful statistics. For example, index-based assets under management have increased 2,610% from 1993. In the U.S. alone, index-linked products represent nearly $1 trillion, and as a result, the active management community is missing out on roughly $12 billion in management fees. And it's not as if that money is going into the pockets of index-based product providers—after all, you can bet they're not getting anywhere near $12 billion in management fees! Sussman points out that if hedge fund replication strategies become successful, there will be significantly more money pulled away from active management strategies—most of which will never leave the investor's hands.
ETFs, in particular, are a significant source of growth for indexing, and since they really got rolling in 2002, index providers have seen their revenues increase at a CAGR of 22%, hitting $860 billion in 2006. The TABB Group predicts that the industry will pass the $1 billion revenue mark by 2009. It is a small but growth-oriented industry.
The Indexing Industry
Sussman notes that indexing has undergone some major changes in the past decade, evolving from a rather informal undertaking in a field with little competition into a highly scientific and structured service in which providers frequently compete head-to-head with each other. Indexes and benchmarks have become vital in locating sources of return, and as such have become important tools for asset allocation.
Sussman hypothesizes that an index provider could claim more market share by differentiating its indexes with better services and information; however, he also notes that index subscribers are primarily concerned with data accuracy. They want information on things like dividend payments, mergers and acquisitions, stock buybacks, etc.
With MSCI currently making some major changes to its global indexes, including expanding its coverage to 99% of market capitalization and calculating its small-cap indexes separately, Sussman says that other global index providers will have the opportunity in the next few years to steal market share if they can build a convincing "value added" case for index users: Those using the MSCI indexes as benchmarks will be making significant and possibly costly changes already to keep up with MSCI's changes, so they may be more open to switching. But Sussman also acknowledges that most index users are slow to change—a TABB survey of pension plans revealed that only 23% of the total had changed their benchmarks over the past few years.
But index providers may also be able to compete in the area of analytics. The report indicates that there is a definite drive by index providers to add analytics to their repertoires, with MSCI's acquisition of Barra the most well-known. S&P acquired ClariFI in May 2007. If data is a concern for users, the added information that comes with in-house analytics could surely be a selling point for an index provider.
The report notes that fees from ETFs and other index-linked products are a key source of revenues for index providers, but that because most of those assets—especially ETF assets—are U.S. assets, most indexes are geared to the U.S. market. This would indicate that indexes geared to international markets would be the next growth area in a growth-oriented industry.
Pension plans and their use of indexes are, not surprisingly, key themes of the report, so I'm going to take a look at them separately. One of the report's key findings is that by 2009, nearly 70% of all pension plans, representing roughly $40 trillion, will use customized benchmarks. One of the drivers behind this is what is known as liability-driven investing (LDI), in which the benchmarks are constructed to reflect the liabilities or obligations of the fund—this approach often uses interest rate swaps to hedge interest rate risk, and thereby frees up more assets to be put into alternative investments. "Pension plans," the report says with regard to LDI, "are not looking to managers for cheap beta anymore but instead are allocating more assets to funds that are focused on alpha capture products."
Another driver for customized benchmarks is socially responsible investing. More restrictions being placed on pension funds with regard to where they can invest—many state plans, for example, are restricted from investing in tobacco companies, while companies with business activities in Sudan are also forbidden to other plans.
The report also cites a survey by TABB that found that 44% of investment managers and 46% of pension funds anticipate increasing the number of benchmarks they use over the next two years or so as they add further asset classes and geographies and expand into new types of investment vehicles.
"Benchmarks used to be an afterthought, now they are primary," the report says in its conclusion, adding that indexing has "opened the door to new markets, decreased the cost of beta, and uncovered new sources of beta."
Based on the report's findings, someone working within the indexing industry cannot help but note how it now seems to be operating from a position of strength. It has transformed from a haphazard collection of rough approximations of the market into an industry marked by competition and precision. Instead of simply tracking the movements of the markets, the indexing industry is actually defining and redefining those markets and providing more ways to invest in previously difficult asset classes. Looking at the report's, findings it appears that, between index improvements and the expansion of ETFs, the indexing industry has the capacity to change the way the world invests.