The do-it-yourself ethos appears to be taking hold within the ETF space. A paper written by Research Affiliates (RA) earlier this month, for instance, argued the case for direct indexing – that is investors customising indices according to their own personal preferences and investment goals.
Yet this might be something of a leap considering the relatively slow progress seen so far with self-indexing; that is, cutting out the supplier middle-man and furnishing your own tailor-made indices.
There are very good reasons why this might be an attractive route, says Timo Pfeiffer, head of research at index provider Solactive. It can be used, as with direct indexing, to solve particular investment aims, risk-return profiles, dividend taxations, geographic exposures and other factors that can meet the exact needs of a discrete cohort of investors.
Or it could be about costs.
“Many index providers charge significant basis point fees to product providers using their license,” he says. “The combination of better product and lower cost is a compelling one, and therefore stirred a lot of interest, when it came up.”
The index space is dominated by the big four – MSCI, FTSE Russell, S&P Dow Jones and Bloomberg – which, Mark Northway from Sparrows Capital says, have cemented their reputations as experts.
He adds this means fund management groups gravitate towards them in order to ensure the best investor reception for their funds.
But Northway ponders whether this “oligopolistic market structure” actually favours the investor.
He cites the example of Lyxor which – regardless of its apparent current travails – has opted to bypass the major providers for its low-cost mainstream equity suite of ETFs by aligning them with Morningstar. Whether that move accounts for what he calls the “tepid” flows is open to question.
Then comes self-indexing. “With self-indexing a manager designs and labels its own specialist index, but in most cases hands the day-to-day calculation process to a third party to avoid conflicts of interest,” he says.
The ESG space is seeing some new ratings and index agencies emerge “under the noses of the larger houses”, he adds. “But we are now beginning to see consolidation here too.”
Yet as Pfeiffer readily admits, while the attractions of self-indexing in terms of cost might attract providers to look at the self-indexing option, it will be the total economics of such a move which could well dissuade them. Most obviously, the simple facts of division of labour would be against them.
“Index calculation is actually cumbersome work, if you got to get the dividend amount right and the ex-date, not only for the largest companies in the United States, but also, depending on the investment universe of your index, for the smaller companies in Vietnam,” he says.
“There is a limit to the efficiency of replicating this ability over and over again in every sell-side institution, specialized index providers can achieve an edge here. Additionally, the practice of market data owners, to invent ever new categories of market data fees, is worsening the economics of self-indexing further.”
Pfeiffer does admit that the largest of the ETF providers might be in a different position having both the capability to set up their own indices and the wherewithal to maintain the work on them. But he goes on to say that they would have one big vulnerability which might stop them from making moves in this direction – conflict of interest.
“The Libor scandal and its aftermath is the perfect example, why ETF providers chose index providers,” he says. “Employees traded against their own index. This is one of the reasons why the European Benchmark Regulation was established.”
Naturally, large entities already have the mechanisms to avoid or prevent such conflicts of interests but sometimes such Chinese walls are not enough. “One simply cannot make sure that the trader, who went on lunch with the employee from the indexing department strictly spoke about non-work-related topics,” says Pfeiffer. “Therefore, to entirely avoid such a vulnerability, they outsource the index calculation and chose an index provider.”
Through the keyhole
But for Northway, when it comes to a provider’s choice of index provider there are still questions to answer regarding transparency and efficiency.
“As ETF expense ratios head ever lower, it is natural for investors to start to wonder what part of the cost of following a given index is the royalty paid across to the index provider, and whether competition is working as well as it should.”
Northway points to the example of the popular the iShares MSCI ACWI UCITS ETF which has a TER of 0.60%. He says the fact sheet makes no mention of the fees paid to MSCI and neither is any mention made elsewhere in the ETF’s prospectus.
“This type of reporting is standard across the industry,” he says. “At one level, what should matter to an investor is the total cost of ownership; but at another level is should be clear how an ETF is being operated, how the TER is being spent, and in particular whether competition is working at each level of the management process.”
Raise matters of competition and the financial regulators should by rights prick up their ears. Northway points out that the benchmarking industry has to date only been looked at from a control and supervisory perspective.
But he believes the regulators should also take a look from a competition standpoint, particularly given the actions that have been taken so far have added to the regulatory burden and hence have stifled the potential for new entrants to provide competition in the area.
“It may be time for the pendulum to swing the other way, with the regulatory attention turning to the proper functioning of the competitive marketplace and to assessing whether benchmark providers are delivering value to the end user,” he says.
As he concludes, “where there is opacity there is inefficiency” and for an industry where costs remains somewhat central to its whole proposition, it would seem strange that such an issue wasn’t being looked at across all levels of the sector, from the suppliers through to providers and on to the regulators.
ETF Insight is a new series brought to you by ETF Stream. Each week, we shine a light on the key issues from across the European ETF industry, analysing and interpreting the latest trends in the space. For last week’s insight, click here.