Self-Indexing—Cause For Cheer Or Concern?
January 05, 2012
Page 3 of 3
“The regulator in Luxembourg, where our ETFs are domiciled, requires us to fill in an eligibility form with a long checklist of criteria if we want to use a proprietary index,” said Manooj Mistry, head of db x-trackers UK. “Disclosure requirements also differ: if we’re using a third-party index we typically give it a one-page description in our fund prospectus, whereas if the index is proprietary the description is usually several pages long. Our index unit, DBIQ, is part of our research team and is separated by a Chinese wall from the business unit.”
The growing trend towards self-indexing is motivated primarily by business concerns, say many fund providers. In an increasingly competitive market index licensing costs threaten to absorb an increasing share of fund fees.
“There’s a natural commercial tension between fund managers and index firms, since benchmark providers form an effective monopoly,” said Deutsche Bank’s Mistry. “They have the index brand and we as product providers have to pay whatever fees are necessary to track their benchmarks. Some index firms can also be inflexible in terms of data, stating that providers can’t disclose index components on their websites in real time, even though we may be required to do so by stock exchange rules.”
Tom Rampulla, managing director of Vanguard’s UK operation, made a similar observation.
“Index firms have gained a lot of market power over the years with the increasing popularity of passive investing,” said Rampulla. “Some of the licensing fees are pretty expensive, especially on ETFs, and are problematic if you’re trying to get the annual cost of a product down to single digits in basis points terms.”
BlackRock’s US application to develop in-house indices might therefore be interpreted as a warning to index firms over their pricing policies, said one ETF market observer, who wished to remain anonymous. It’s still unlikely in practice, though, said the observer, that proprietary indices would be used for any but a small group of funds using so-called “smart beta” strategies, involving semi-active management and frequent benchmark rebalancing.
In summary, the trend towards increasing in-house provision by asset managers of their passive funds' benchmarks promises lower costs to investors, but also raises questions over conflicts of interest and governance. Regulators’ stance on the separation of duties between index provider and asset manager remains rather unclear and is inconsistent between the US and Europe. While an understandable development on commercial grounds, it’s an open question whether the growing self-indexing movement is cause for investors’ cheer or concern.