Editor's Note
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The Inside Scoop The Editor of the Journal of Indexes takes a look at the latest developments in the index industry.This issue he discusses the recent surge of acquisitions in the industry and the implications of these deals. The Editor of the Journal of Indexes takes a look at the latest developments in the index industry.This issue he discusses the recent surge of acquisitions in the industry and the implications of these deals.The index industry is in the midst of a frenzy of expansion and consolidation. Now that thousands of indexes for every asset class blanket the market many times over, major index providers and index fund managers are beginning to disarm. The index stragglers are being reigned in through mergers and buyouts, and some of the sillier, faddish index products are being disbanded after failing to gain traction. S&P started the trend by buying out the upstart Citigroup Solomon Smith Barney Indexes. Now both Dow Jones and MSCI have become more acquisitive than a Saudi prince in Beverly Hills. MSCI has purchased the Barra Indexes while Dow Jones has moved in to take over the marketing and management of the Wilshire indexes. All three of these deals open up some interesting scenarios. S&P truly has gone global with its purchase. While previously S&P had dabbled internationally with strategic branding alliances with major international exchanges and the purchase of the erstwhile IFC's emerging markets indexes, the Citigroup deal adds a whole new array of international data to the fold. The purchase may well lead to S&P aiming directly at its partner in developing the Global Industry Classification Standards, MSCI. And why not? MSCI initiated the turf war in the U.S. equity index business with the introduction of its U.S. domestic index series last fall. MSCI will make it a two-pronged attack now. In a bid to become more stylishly American, MSCI has returned the most recent S&P favor with a buyout of Barra. It will be interesting to see MSCI licensing indexes to S&P, which uses Barra for all its S&P style indexes. Wilshire, for all the academic cache its Wilshire 5000 index has enjoyed, has never made much in licensing fees from its indexes. Its forte, like Russell's, has been in the consulting business. And now, interestingly, Dow Jones Indexes, by taking over the Wilshire Indexes, has more tools to compete with its partners in global standards, Russell. Already with its eyes on the U.S. total market market with the Dow Jones Total Market Index, Dow Jones has gotten some attention with listed futures contracts and ETFs, and with iShares placing some focus on the TMI index family. Which leads us to ETFs. We put together an interesting data set this issue, that compares where the largest ETFs were at the end of Q1 2004 and at the end of Q1 2003. (See the opposite page.) And look who's running away with the ETF pie. It's not the leaders. The two behemoths, SPY and QQQ, still have virtually the same level of assets. Indeed, if you look at the returns, both actually suffered a net redemption of assets. Move down the table and you'll see where the bulk of U.S. ETF asset growth has come from in the last year. Interestingly, the iShares S&P 500 ETF seems to finally be making headway on the grand pappy of them all, the SPDR. Indeed, State Street Global Advisors has taken notice, recently lowering the expense ratio of the fund to 10 basis points, in comparison to iShares IVV's 9.45 basis points (that would be 0.0945% for those of you who are statistically uninitiated or are lacking a microscope).
This is a far cry from when the iShares first came out, and a lot of people (including those at BGI, I suspect) thought that by undercutting SPY on price that the assets would immediately flow to the BGI fund. This logic made sense, because most of the investors in SPY were more institutional investors, and BGI had the preeminent reputation as a first class institutional index manager. Alas, the brand name of the actual ETF turned out to mean something to even the big cats. Indeed the skeptics were borne out initially, as the iShares paid out some rather unfortunate early distributions that had to do with cashflow management problems, something one would have expected BGI to be extremely adept at. But they appear to have worked out the kinks, and the assets have flowed since, as the iShares brand has come to have power in its own right. In some quarters, I've seen the term "iShares" used in place of ETFs, like "Kleenex" for tissues or "Coke" for any soda (OK, that's only in the south). Meanwhile, on the other side of the dodgeball court, SSgA has quietly stood while other players have been picked off and suffered flat or negative asset growth. With a massive costcutting effort, SSgA trimmed the rolls and focused its efforts on attracting assets, LOTS of assets, and on moving clients toward more high-margin active products and just letting the ETFs run themselves. And the assets came (though not to the ETFs). SSgA became the largest investment manager in the world last year, growing assets by an astonishing 58% to $1.24 trillion dollars (the contribution of these assets to the U.S. government would significantly improve the state of the U.S. budget). So if you total ALL the ETF assets in the entire world, these amount to about 20% of SSgA's assets alone, and a tiny percentage of the overall mutual fund market. So there's plenty of room to roam. And roaming is what they've been doing. To get back on this "Scoop's" theme, both BGI/iShares and SSgA have been on ETF-related buying sprees of their own. iShares has long been at it, locking up exclusive ETF licensing deals with many of the major indexes to cut off all competitors at the pass. Because of this, Vanguard was forced to come up with new indexes altogether (read the new MSCI U.S. domestic series) just to be able to properly do its ETF launch. iShares latest notch on the belt is the Morningstar indexes, which were nearly licensed by UBS Global Asset Management/ Fresco Shares before that deal fell through. Of course now UBS is getting out of the ETF business in the United States altogether, leaving its promising but disappointing STOXX ETFs to (you guessed it) SSgA, while iShares picks up the lost Morningstar indexes deal. There's speculation that BGI just snapped up the Morningstar indexes to prevent anyone else from licensing them. Clearly, however, despite BGI already having a number of stylebased ETFs, including the Russell and S&P/Barra/MSCI style ETFs, the Morningstar indexes tap into BGI's core target audience, which consists of financial intermediaries like Financial Advisors and Registered Investment Advisors (yeah, YOU). So it will be interesting to see how this plays out and how those funds and the recently launched New York Stock Exchange funds are marketed. And now for something completely different. At the last ETF conference in Key Biscayne, I could sort of sense this big purple hairy monster prowling the grounds, though no one much talked about it. It's the underperformance monster. Bill Bernstein did a comprehensive study comparing ETFs to their equivalent (mostly Vanguard) index funds, and the results were not entirely favorable for ETFs. In fact, in most asset classes, the ETFs were underperforming, sometimes significantly. Well, let me let you in on a little secret (OK, maybe it's not such a secret). Almost ALL other index funds (and active funds, of course) are underperforming the Vanguard funds. The irony is that the reason the Vanguard index funds perform so well is that they are active. Vanguard very actively manages its cash flow and the timing of the trades during index rebalance, while making optimal use of derivatives and securities lending for the portfolios to perform as well as they possibly can while still walking in lockstep with the underlying indexes. In many cases the Vanguard funds are actually able to nominally outperform the indexes, and very often they a re at performance points that are inside their expense ratio. A pure index fund, on the other hand, would be expected to underperform the index by at least the cost of running the fund. So my point is that all of this has nothing to do with the ETF structure. Any underperformance simply has to do with how the assets of the fund are managed. So in a regular open-ended ETF (as opposed to the trust structure that the earlier ETFs from SPY to QQQ are set up as, which have less flexibility) the ETF manager can do everything that the manager of a traditional mutual fund can do in terms of securities lending, use of futures, discretion on trades, etc. But ETF managers by and large have chosen not to get into that game, and to make trades when the index changes, and yes, lend securities and manage cash flow, but not to actively pursue alpha. So a Vanguard (or anyone else who chooses to do it) could be expected to get the same results in an ETF, with some cost benefits and some tax benefits. In the tax efficiency area, Gary Gastineau gives the nod, in the area of 50 bps a year on a taxable account, to the ETF, while Vanguard's Gus Sauter gives the efficiency nod to the traditional mutual fund, a structure he obviously knows as well as anyone. The area where a traditional fund could have a slight advantage would be in 1) a down market, and 2) the ability to use cash flow to dull the effect of index changes. ETFs do all of their inflow and outflow in the underlying shares and not in cash. It will be interesting to track the Vanguard share classes to see how they do. It will also be interesting to see if SSgA and BGI respond to some of the criticism and move toward a more active management of their index funds. Well, I'm already out of space… and I was just getting to the really juicy stuff. |
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By Jim Wiandt
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