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.)

Important Statistics

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.

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