One of the primary selling points of the ETF industry (and index tracking in general) has been that it reduces costs for investors. Last year, we saw that trend accelerate, with costs on many high-profile ETFs heading well below the 0.1% level, and Fidelity even launching zero-fee index trackers (in the form of mutual funds rather than ETFs) in the summertime.
With costs now so low, 2019 could see the spotlight fall much more heavily on the mechanics of the ETF and index-tracking industry in general, as providers have to find other ways to compete. And while it’s good news for investors on many levels (who doesn’t love cheap funds?) it also promises to throw up a few headaches for the unwary. And it’s largely down to the growing popularity of “self-indexing”.
What is self-indexing?
When your typical investor decides to buy an index fund, their goal is usually to track a well-known stock market index. In the US, that might be the S&P 500, and in the UK, it’ll be the FTSE index in some shape or form. Of course, while these are the best-known indices, they are not publicly-owned goods. Someone constructs and calculates those indices – in this case, Standard & Poor’s and FTSE Russell respectively. So if you’re a big asset manager looking to provide a product that tracks a well-known index like the S&P 500, you have to pay S&P a licensing fee for the privilege.
In the early days of selling tracker funds and ETFs to customers, this licensing fee was easily covered by the asset management fees rolling in. However, as price competition in the passive sector has reached a cut-throat pitch, so the cost of licensing the underlying indices has become an ever-greater chunk of the cost base. And it’s hard to deny that the index providers have done well from being so dominant in their respective areas – according to Ari I Weinberg, writing in Pensions & Investments last year, S&P Global reported a 67% operating profit margin in its index business for the half year to June 30, 2018.
As a result, if fund providers want to cut costs any further while maintaining a sliver of margin for themselves, then they need to bear down on the index licensing cost. They could prevail upon the index providers to cut their costs, and that’s certainly likely to happen. But another option is simply to build an index that meets their requirements for themselves – you can still outsource the calculation process, but if you build the original index yourself, you don’t have to shell out any licence fees. Hence the name, self-indexing.
Self-indexing is already a standard feature of the more specialist ETF providers – those who put together smart beta indices, for example. WisdomTree, for example, was one of the main pioneers of self-indexing. But now it is spreading – the reason Fidelity could offer their range of fee-free tracker funds is partly because they self-index. And as the trend spreads, individual investors can expect to see price competition continue.
What does it mean for you?
The big question, to my mind, is this: given that tracker funds and ETFs are already so cheap and widely available, will the prospect of cutting a few more basis points off the cost really make that much difference to the average private investor? From an industry point of view, there is a rationale here – advisers in the US now have a fiduciary duty to act in the best interests of their clients, and one way to prove this in a way that’s visible to the regulator is to use the cheapest funds on the market. But for individual investors, I suspect that the rise of self-indexing at this level (as opposed to the “value factor”-type smart beta funds), has the potential to add more confusion than it’s worth.
Let’s say you want to invest in a diverse spread of US stocks. The Fidelity ZERO Total Market Index Fund tracks the Fidelity US Total Investable Market index, which comprises 2,500 stocks. This compares to the 3,809 held in the S&P Total Market index. Over the three months to the end of January 17th, the underlying Fidelity index was down 4.23%. The S&P index on the other hand is down 4.18%. That’s a tiny gap, but it does start to reveal the pointlessness of quibbling over a couple of basis points in costs. And that goes double when you point out that the Fidelity ZERO Total Market Index Fund is in fact down 4.43%, compared to the aforementioned 4.23% for its underlying index.
My point here is not that any of these indices or funds is better than the other. My point is that you can really end up going down a very deep rabbit hole obsessing about which of these exceptionally cheap funds is in fact going to offer you the best value over time. With prices already as low as they’re going to get, the biggest cost for most private investors will instead be the broker or platform they use to own these funds – as far as the fund itself goes, I suspect most will just be inclined to stick with the big-name providers, rather than trying to tease out the differences between indices that are all ultimately designed to copy one another.
So while price competition will be one driver of self-indexing, I suspect that what we’ll really see more of this year is a proliferation of indices with varying types of ESG overlay. One easy way to distinguish your product from the competition – and grab a bit of PR on the way (for the cynics among you) – is to find a new way of reshuffling your index construction to give it a veneer of environmental or social activism.
A harder way – but one that might have more impact in the longer run – is for passive fund groups to pitch themselves as genuine activists, taking up the more serious challenge of acting as owners, rather than intermediaries. By acting to restrain executive pay; drive forward thinking and investment rather than share buybacks; and generally representing the interests of long-term shareholders, big ETF providers and passive asset managers really could stand out from the crowd.
Of course, the irony is that this would make the more active than many so-called “active” investors. But that would be no bad thing.