Photographer: Andrew Harrer/Bloomberg
New Twist in Race to the Bottom for Fund FeesBy
New rules next year may push up licensing cost of indexes
Managers turn to ‘soft-indexing’ and cheaper index providers
In the race to the bottom for fund fees, Europe’s regulators are about to introduce a new twist.
Starting next month, indexes used in the region, as well as the providers selling them, will be overseen by national regulators. The new rules, introduced in the wake of index manipulation scandals, will add another layer of expenses to an industry already facing pressure to consolidate. For the money managers that use indexes to create cheap passive mutual funds and exchange-traded funds, the change could push up licensing costs and tilt the playing field further in favor of large providers.
Licensing fees are “not negligible,” said Isabelle Bourcier, head of ETFs at BNP Paribas Asset Management which oversees 26 billion euros ($31 billion) in passive products. They can be “as high as management fees for ETFs which have a low total expense ratio.”
The cost of licensing, which is typically determined as a percentage of a fund’s assets, can range from one basis point to around 10 basis points for the more sophisticated indexes. With fees for the largest funds now just a few basis points, even small increases in the cost of an index can erode the slim profit margin, particularly for smaller investment firms that have less negotiating power and can’t afford to create indexes in-house.
“It’s possible that the economics of licensing indexes will change,” said Andrew Sulston, a partner at law firm Allen & Overy who specializes in indexes and benchmarks. “Because the compliance burden for administrators of indexes has increased, license fees might also increase.”
The rules, introduced in response to scandals such the manipulation of the London interbank offered rate, are designed to remove potential conflicts of interest, for instance when a company that sets benchmarks also stands to make or lose money from them through its own trades. They will impact all types of indexes including broad stock market indexes such as the FTSE 100 or the S&P 500.
The new rules “definitely will increase cost, especially with compliance,” said Rick Redding, chief executive officer at the New York-based Index Industry Association, the trade body that represents index providers. “But whether that gets passed through will depend on the provider and the competitive environment.”
MSCI Inc. charged on average 3.05 basis points of clients’ ETFs assets in the third quarter, meaning a $10 billion fund tracking an MSCI Index would on average pay $3.05 million in licensing fees. While all funds that use external indexes have to pay some form of fee, it tends to be lower for active funds that merely mention the index as a benchmark, and for indexed funds where branding is perceived to matter less.
MSCI Inc. declined to comment on whether it would pass on higher costs to clients, as did the London Stock Exchange Group Plc, which owns the FTSE Russell indexes, and S&P Global Inc. LSE has around $15 trillion in assets that follows its benchmarks, with MSCI and S&P Dow Jones indexes each having about $10 trillion.
Bloomberg LP, the parent of Bloomberg News, competes with the firms in providing indexes.
Fund companies have for years pushed to lower the cost of indexes amid a fee war to attract the most assets. Vanguard Group Inc. and BlackRock Inc., the world’s largest money managers, have been slashing fees for their most popular offerings, pushing the expense ratio for funds such as the iShares Core S&P 500 ETF to 4 basis points, or 0.04 percentage points.
To offset the lower fees, some firms are shopping for cheaper indexes. Vanguard five years ago dropped MSCI as index providers for funds with more than half a trillion dollars in assets in an effort to cut expenses. Last year, more than 80 funds changed their benchmark, the most since at least 2010, according to specialist data provider ETP Resources.
“When selecting benchmark providers, Vanguard focuses on identifying indexes which are transparent, well-constructed, and meet Vanguard’s standards on indexing methodology best practices, all at a reasonable cost to end investors,” said a spokeswoman for the firm. The firm is aware of the new European rules and has examined whether to produce indexes in-house, but so far is sticking with outside providers, she said.
Among the beneficiaries of the trend are smaller index providers such Germany’s Solactive AG, which has $100 billion assets tracking its benchmarks.
“Our policy is to charge based on the workload required,” said Steffen Scheuble, chief executive officer of the company. “It is not yet foreseeable how much the workload will increase. However, we are determined to maintain our very competitive pricing structure in the market.”
Other money managers have started to produce indexes in-house. BlackRock started its first self-indexed funds last summer to reduce manufacturing costs and Charles Schwab Corp. in October began offering a stock ETF that tracks a proprietary index of the 1,000 largest U.S. companies. Such “soft indexing” will also fall under the new European rules, at least for products sold in the region, so it’s unlikely to be feasible for smaller firms that can’t afford to shoulder the additional cost.
“With the benchmark regulation, some asset managers are looking at smaller index providers or perhaps looking at soft indexing,” said to Deborah Fuhr, founder of the consultancy ETFGI and a former BlackRock executive.
WisdomTree Investments Inc., a $48 billion ETF provider known for its smart-beta offerings, has been developing its own indexes since 2006, but the firm outsources the calculation to third party providers to preserve the independence of the benchmarks. WisdomTree still pays a fee for the calculation, but it’s independent of the size of the fund, said Nizam Hamid, the firm’s ETF strategist.
In the long run, observers say, the new European rules could accelerate a consolidation in the industry, including among index providers.
“A lot of benchmarks are going to disappear,” said Bruno Piers de Raveschoot, chief operating officer of the regulatory division at Rimes Technologies, a financial services provider. “Some benchmark providers are in the process of deciding if they want to continue to supply indexes to Europe or stop because of the cost.”