Self-indexing: should index managers track their own proprietary indices?
The rise in popularity of index tracking strategies has delivered strong revenue growth for index providers over recent years. Effectively, index providers design indices for index managers to track, and charge a nominal licence fee for this service. The big three index providers, MSCI, S&P Dow Jones and FTSE Russell, have been exceptionally successful in increasing their dominance in the market with a combined market share of almost 80% currently, as strong brand recognition and economies of scale have made their business model successful.
On the other hand of the equation are the index managers who pay the licence fees to track these indices. Often these fees can be a large burden for low-cost products, and with the competitive race to cut costs for customers, large index managers have been driven to seek cheaper options. As an example, Vanguard, the world’s second-largest fund manager, in 2012 discontinued using MSCI and moved to the services of the Center for Research in Security Prices and FTSE Russell. More recently, State Street Global Advisors swapped out MSCI for German index firm Solactive for four of its exchange traded funds (ETFs), reducing their expense ratios significantly.
The more fundamental movement, however, has been fund managers building their own indices, commonly known as self-indexing. Factor investing specialists such as WisdomTree were among the first to take this route and others have followed suit, including BlackRock, State Street, Invesco, Fidelity and Charles Schwab.
Clearly, there are advantages and disadvantages to self-indexing. Let me begin by addressing a few of the perceived disadvantages:
1. Research and infrastructure expenses
Self-indexing requires the index manager to build capacity that can cope with the rigorous requirement of research, which can be both costly and lead to longer lead times for fund launches. Moreover, creating a proprietary index requires a completely different skill-set to simply performing index due diligence.
2. Governance and regulatory concerns
One of the requirements of any index is transparency, where investors need to be able to easily assess the rationale behind an index, its construction and methodology. It is therefore key that any manager who follows the self-indexing approach provides clear and understandable documentation to regulators and investors. Furthermore, concerns regarding segregation of duties between index provider and index manager have recently been raised by regulators. However, this can be solved by having an independent index calculation agent.
3. Proliferation of indices
The number of indices on offer is rapidly increasing, with large growth in more specialised indices in fixed-income, ESG indices, and factor-based (smart beta) indices that tilt towards styles such as value, momentum, and quality. While index managers are now also providing new and innovative indices to benefit investors, the proliferation can become overwhelming.
Now for a list of some of the advantages of self-indexing:
1. Value-adding intellectual property
With self-indexing, an index manager employs its intellectual property to build an index which is differentiated from off-the-shelf indices offered by index providers. The value proposition here is that the index manager offers strong research expertise and insights through partnering with institutional clients to build targeted solutions that solve specific investment objectives.
2. Factor based customisation
The argument commonly used against self-indexing, specifically related to the creation of proprietary factor strategies, is that only straightforward, academically tested factor definitions serve clients best – suggesting that practitioners utilise complex, unproven or data-mined factors. The reality is not the case, as often academic research does not fully understand the nature of specific equity markets. As an example, employing an academically accepted factor definition for value in South Africa would lead to using price to book as the value measure. This, however, would lead to inferior outcomes in contrast to applying appropriate valuation definitions per major sector, an idiosyncrasy only understood through a deep practical understanding of factor investing in South Africa.
It’s NOT all about the costs
Cutting out the middle man sounds like a promising approach to cost saving, but the creation and ongoing maintenance of an index require specialised resources and would naturally bear significant costs. In addition, even when self-indexing, the costs of index calculation through an independent agent to calculate the index would still be required, and thus the full benefit of lower index licence fees cannot fully be passed onto investors.
Does the index manager really have additional insight?
Index managers who are considering self-indexing should not take this on lightly. Designing and rebalancing indices in real-time within a regulated environment is often not as easy as it looks, and requires specific data, expertise and insight. Where index managers have these resources, the investment results can potentially provide greater scale, product choice and allow a solutions-based approach to solving clients’ requirements, specifically for institutional clients.
Demand for index providers will remain
Ultimately, there will always be a demand for strong brands such as MSCI or S&P where well-known indices are preferred, particularly where these indices are popular as broad benchmarks as a reference against portfolio performances. Many of the large index managers value the construction methodologies, objectivity and credibility offered by independent index providers, coupled with the reasonable cost arrangements.