Planets and rising stars: change in the indexation universe

The financial market index is diversifying – could it go the way of the music industry? 
by Richard Willsher

Think of the first financial market index that springs to mind. 

Chances are you chose S&P, FTSE or MSCI. Every media financial news bulletin, scrolling update or newspaper finance section will carry a reference to one or more these major brands. In our minds they have become synonymous with market performance.

This is by no means the whole story. A database of index providers compiled by exchange-traded funds (ETF) consultants ETFGI runs to 191 separate names. Some are familiar in the finance world, like Bloomberg, Markit or STOXX. Others are those of stock exchanges around the world. Others are banks such as Barclays, Deutsche Bank, Credit Suisse or Citigroup. Then there are those that are relatively new, but which are making their names as providers of specialist indices such as ScientificBeta, Solactive and Horizon Kinetics. The more you look, the more it becomes clear just how diverse the index universe really is. 
The planetsThe masters of the indexation universe are huge and profitable by any measure. Their indices are used to track behaviour in bonds, equities, commodities, currencies, derivatives and structured products. 

The Boston Consulting Group calculates that the value of global assets under management (AUM) totals $71.4tn. The S&P 500 is the world’s most followed stock market index with $7.5tn benchmarked to it. MSCI reports that $10tn of AUM is benchmarked to its indices. FTSE Russell, part of the London Stock Exchange Group (LSEG), also claims that $10tn is benchmarked to its products. Just totalling these three numbers amounts to 38% of global AUM. This leaves the remaining 62% of total AUM to be benchmarked to other indices produced by S&P or by the remaining 188 providers.

In terms of revenues and profitability, providing indices is very nice work if you can get it. S&P Indices reports total revenues of $639m for 2016, on which it made an operating margin of 64%. MSCI’s Index revenues for 2016 amount to $613.6m, on which it reports an earnings before interest, taxes, depreciation and amortisation (EBITDA) margin of 70.3%. LSEG reports revenues for 2016 of £594.7m ($790m) for its information services division, which includes real time and other data it provides. It made an operating margin of 56.5%. While these numbers may not be directly comparable, they do indicate the level of profitability of these firms’ index business.

These profits are typically generated from: investment vehicles such as ETFs, where the fee is calculated on the assets or underlying funds; royalties on exchange-traded derivatives based upon volumes traded; index-related licensing fees for over-the-counter derivatives and retail-structured products; and other fees for supplying data of various sorts. 

Major brand indices compared*
   FTSE Russell MSCI  S&P DJI 
 AUM benchmarked $10tn  $10tn  At least $7.5tn 
 Index revenues  $790m (£594.7m) $613.6m  $639m 
 Profit margin  56.5% 70.3%  64% 

(*These numbers are for indicative purposes. They not directly comparable as each provider is differently organised and their reporting varies.)

Sources: 2016 annual reports

PassivesThese major brands have enjoyed the benefits of the rapid growth in passive investment products, particularly ETFs. For example, S&P’s 2016 annual report notes that: “Revenue at indices increased 7%, primarily driven by higher average levels of AUM for ETFs and mutual funds, an increase in data revenue and higher volumes for exchange-traded derivatives.” 

That’s the good news. The not so good news for them is that firms selling ETFs, such as BlackRock and Vanguard, are keen to keep costs to a minimum. In October 2012 it was reported that Vanguard switched six funds worth $170bn from MSCI to FTSE and a further 16 US funds worth $367bn from MSCI to benchmarks developed by the University of Chicago’s Center for Research in Security Prices (CRSP) in order to lower costs. 

A number of institutions, including banks such as Goldman Sachs, have been producing index research and benchmarks for many years, using them in their own fund management businesses.

Meanwhile, Deborah Fuhr, managing partner and co-founder at ETFGI, confirms that fund providers would dearly like to lower their index licensing costs, and new index providers are popping up, offering lower cost models to create indices.

One such provider is Frankfurt-based Solactive AG. Research from Bloomberg finds that, in 2017, Solactive provided indices in support of 69 funds out of 450 newly-issued passive funds. Solactive’s website says: “We have an aggressive pricing model to optimise client’s costs.” Its indices span equities, bonds and a large range of indices that support quantitative and systematic asset management strategies.

Solactive’s CEO and founder Steffen Scheuble explains their approach: “We are, in many areas, in competition with the well-established index providers – we call them brand managers as they have a strong brand and pricing power … Solactive is substantially cheaper than these providers.” He would not be drawn on how much cheaper.  
ThematicsWhile the juggernauts of well-established indices like the Dow Jones Industrial Average or the FTSE 100 roll on, year after year, an industry of specialised, thematic funds is developing rapidly. Some are called smart-beta indices, others include ESG – environmental, social and governance – indices, others follow so-called factor indices. The key to their index structures is that they select particular listed companies, sectors or types of business and track the pricing of these firms. 

The major brands also offer a very large number of index products, as well as their household name indices. S&P, for example, says: “S&P Dow Jones Indices calculates one million indices and our coverage spans asset classes, geographies and investment strategies.” Similarly, FTSE Russell and MSCI produce a great many indices, slicing and dicing the massive bank of data they have at their disposal. 

Smaller players have to overcome the strong brand preference of some investors, especially pension funds and other institutions, who are unlikely to be criticised if they adhere to major brand indices. Deborah explains: “Certain benchmarks resonate with certain clients. For others, it’s not as important.” In addition, indices-based funds, like ETFs, have to find investors. More indices don’t necessarily mean more money flowing into them. 

Moreover, while concentration risks probably do occur as a result of the popularity of certain indices – the FTSE 100 and S&P 500, for example – funnelling more and more funds into larger stocks, the vast bulk of new indexed funds are small by comparison with the more established ones. In addition, while comparing indices could potentially present a problem, especially as they would likely use different methodologies to select index components, investors are likely to be most interested in the level of return potentially available from tracking a chosen index, versus the risks they perceive and are prepared to shoulder.   
The futureBloomberg acquired the Barclays index business in August 2016. Barclays had previously acquired it from the wreckage of Lehman Brothers. In doing so, Bloomberg gained a major position in the fixed income index market where Barclays is a dominant player. 

Steve Berkely, global head of indices at Bloomberg, said: “Technology is key. It will bring vast changes. For example, fixed income indices are produced only once a day at present because of the lack of real-time pricing. I think that this will be resolved by companies with technology like Bloomberg. I think you’re going to see greater transparency of information, through terminals like ours. This represents the democratising of information. I think there is going to be a big push of information into the hands of users.

“People will be able to create customised indices by accessing historical data by the themselves. In the past it was only the most advanced organisations that could manipulate data and come up with different types of analyses. We are working towards enabling smart people, with good ideas, to come up with new investment products.”

This is a quite a vision for a sector that has stuck with the main indices for a very long time and whose major brands still command high margins. If Steve is right, those big businesses should be worried and so should smaller ones whose offerings cannot outsmart the competition. An analogy might be that of record labels in the music industry, where today a young musician with the right software and the right skills can produce a hit ‘record’ from their bedroom and post it on YouTube. In the end, even though the position of the majors in the indexing universe looks secure, nothing lasts forever.  

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Published: 16 Nov 2017
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