Power index: ETF boom creates an oligopoly of index companies
This week, I thought I would share a little secret with readers: Managing indexing companies is an incredibly lucrative business. Now, I suspect the world’s weary among you will tell me that you already know that. But I think you probably haven’t realized how lucrative this business really is and why it could become even more so because of our friends, the regulators.
Let me start by taking you on an adventure through some tough numbers.
S&P Global’s index division may only account for around 15% of the fintech giant’s total revenue, but hey, what a company it is. In 2020, it generated just under $ 1 billion in revenue and operating profit of $ 666 million. Some $ 4.2 billion is invested in products linked to the company’s indexes, of which $ 2 billion is in ETFs. If I were a corporate financier I would knock on S&P Global’s door and suggest they turn the index business into a fantastic PSPC – see no reason why this one company alone couldn’t be worth 50 times its profits. .
MSCI’s reports are also enlightening. This is a much cleaner index business model, that part of the business dominating revenues of around $ 1 billion (of which ESG product lines alone generate $ 121 million in fees) with operating margins close to 60%. In total, there are around $ 1.2 trillion in ETF-related assets.
I want the reader to dwell on these numbers because it is a reminder that despite all the waffles on ETF base point charges approaching zero for large ETFs, the reality is quite different. Running an ETF issuing company can become more difficult, but for large index companies the opposite is true. And arguably, it’s getting more and more profitable, with most of the big players predicting 10-12% revenue growth, and even higher profit growth than that.
Why might the outlook improve for index companies? First of all, because if we go through the list of the top 100 ETFs by assets under management, with one notable exception, we see a market dominated by a select group of S&P Global, MSCI, Nasdaq, FTSE Russell and the strange Bloomberg Barclays. Fixed income ETFs. That one exception is Vanguard, which has voluntarily decided to track major asset classes using the Chicago Booth CRSP indices, presumably at a small fraction of the cost.
There is currently a broader debate among economists that, despite decades of supposedly proactive competition, large swathes of US businesses are in fact dominated by a handful of oligopolistic players. That’s great news for investors looking for quality, high-margin, wide-moat companies, but less good news for the rest of us. I would suggest that index activity ticks most of the quality boxes, and all for largely reasonable reasons. It’s a game of branding, respectability, in-house research and computational expertise. I don’t blame ETF issuers, or even ETF buyers – you, the reader – because you probably need to explain to someone who is less financially literate than yourself why you bought an ETF from an ETF. index company limited by shares. “What’s wrong with an S&P 500 tracker, Dave? “
But there are other factors at work. The first is that as ETF buyers become more demanding, they also demand expertise in areas such as alternatives, thematic and ESG. At one point, I thought this would be an opening for independent index companies to get in and take up business, especially in the ESG area. But guess what happened? The companies in the index simply bought the smart new talent and incorporated it into their offering, starting with Kensho (for thematic) from S&P, then with Sustainanlytics (Morningstar) or Carbon Data (MSCI). Today, these companies are in a profitable environment. As investors invade this space, they seek high-level brand validation for contrasting ESG data sets, which, of course, helps the big historical players.
Payment to come?
However, another tailwind looms on the horizon: the potential for regulation here in the United States. A recent article by two academics argues that many new generation indices (tailor-made and personalized) are in fact a surrogate form of investment management, but without the usual regulatory clearances for investment management. On this point, it is worth reading an article entitled ‘Advisors under another name‘by Paul Mahoney of the University of Virginia Law School and Adriana Robertson of the University of Toronto Law School.
The silver line in their convincingly argued article is that it is increasingly evident that as indices become more actively constructed – think tailor-made or tailor-made – they need a regulatory approach. more active. Or, as the report suggests: “index providers who provide personalized advice, including creating or modifying an index at the request of the index user, would be treated as an investment advisor. “.
Index providers who maintain more generic, out-of-the-box universal indexes, on the other hand, should be able to benefit from what the authors suggest is “a conditional, non-exclusive safe harbor that sees them as not being advisers. in investment … In order to benefit from this safe harbor, index providers would be required to comply with certain disclosure obligations. ‘
This all makes sense, but I would say it could have an unexpected result: it will concentrate power on the small number of existing dominant players, who will have the financial and lobbying power to run a more intrusive regulatory regime.
Another way to look at the same process is to recall the various scandals surrounding the Libor interest rate benchmark. Knowledge of these “bad practices” had been catching on for an absolute age, and many academics had identified the abuses before regulators noticed. You can see the concerns outlined in a 2013 document titled ‘Clue Theory: The Law, Promise, and Failure of Financial Clues‘by Gabriel Rauterberg and Andrew Versteint, who concluded that the Libor was flawed, in part because no one was doing a job deep enough to own the index and then protect it from abuse. The academics suggested that there was an “irreducible subjectivity built into index production. This subjectivity, which is a key element in the value of cues to users, also carries the potential for manipulation and malproduction. ‘
They argued that one of the best ways to protect these indexes was, counterintuitively, to increase the intellectual property protections of “current index providers,” which means giving index owners even greater control over intellectual property.
And in this last point there is the seed of true insight. As indices become more important to investment results, they will generate more complaints about abuse and bad practices. This, in turn, will cause regulators to want to blame someone, meaning the companies in the index will need more, rather than less, protection for their rights so that they can provide an appropriate channel. of paperwork to curious regulators. All of this reinforces the power of branded companies.
So, dear reader, as a buyer of said index products via ETFs, what can we offer as remedies for this growing concentration of power in index firms? I would suggest three practical ideas that I think we can all support. The first comes from the original academic article I cited above, which suggests some sort of “simple” reform: If index companies benefit from the Safe Harbor regulatory exemption, then they may be required to disclose costs to the end investor. I think we all need more transparency about the cost of these increasingly personalized indexing services.
Related to this, there is a more practical suggestion: each index should not only have a very clear and investor-friendly ‘how-to’ document, but also a clear name and email address for an index owner who can explain to advisors the thought behind a clue. In simple English.
I also encourage advisors to build on Vanguard’s adoption of academic index sources and suggest that regulators encourage the development of open source (and open-code and -data) index alternatives. The idea here is to encourage new innovators to come up with generic versions of indices at low or no cost, as well as to encourage innovative researchers to develop new bespoke indices that will solve complex investment problems.