Indexes’ Long Walk to Freedom

As any elementary economics class will tell you, greater competition should lead to lower prices. Yet in the indexes arena, costs are rising, despite the entrance of companies offering low-cost and even free-to-use indexes as alternatives to traditional indexes. In some cases, these rising costs have forced firms to put their money where their mouth is and switch providers. For example, in 2012, Vanguard Group, the largest US mutual fund manager, replaced MSCI as the benchmark for 22 funds with indexes from FTSE and the University of Chicago’s Center for Research in Security Prices, while two UK-based boutique firms dropped FTSE from their client literature after being told that referencing the indexes would cost up to £15,000 ($18,800) per year.

So far, low-cost and free providers have experienced limited success, with asset owners naturally skeptical of new faces, and mindful that “you get what you pay for.” But with Chicago-based investment research and data provider Morningstar recently making its key indexes available free of charge for benchmarking, and Euronext planning an expanded index business with fee-free options, the industry will have new, credible alternatives that could disrupt the traditional economics of index provision.

In recent years, index providers have flooded the market with new benchmarks—each slightly different, but none with such a proprietary nuance that it can’t be easily mimicked—resulting in higher costs and an increased management burden. 

“We’ve seen a proliferation of benchmarks. We process a lot of benchmarks for hundreds of clients now,” says Steve Cheng, global head of data management solutions at Rimes Technologies. The vendor’s Benchmark Data Service provides files of validated index data to client applications, and Rimes also offers a tool for monitoring index data license costs and usage. “Because we are currently in a low-returns environment, it’s harder for asset managers to make money, so they are looking for new ideas to beat the index and differentiate themselves. It’s harder to be a successful active investor, which is why there’s more demand for custom indexes … and index costs are going up.” A cynic might also note that so many custom indexes make it harder for consumers to compare like-for-like index performance and costs, Cheng adds.

Carl Bacon, founder and chief executive of UK-based not-for-profit index provider The Freedom Index, says this proliferation of indexes is coming from a small number of index providers, who are “exploiting high barriers to entry” and charging fees that are disproportionately high to the value of their index benchmarks, which will ultimately prompt new entrants despite the barriers.

“There is a disconnect in the industry: There is a tremendous focus on asset management fees and expenses, which is great for investors, but if you’re a consumer of index data—not for creating index-linked products, but for benchmarking—the cost has been going up.” Sanjay Arya, Morningstar Indexes

An index provider since 2002, Morningstar is hardly a new entrant, though it is taking a new approach, announcing in November that it will make its global equity indexes available at no cost for benchmarking purposes, including price return, total return and net return data, with month-end constituent data.

Morningstar began the initiative—and set up an advisory council of 25 end-user firms, including Eaton Vance and Guggenheim Investments—in response to clients’ frustration with the cost of benchmarking and the perceived barriers to switching providers.

“There is a disconnect in the industry: There is a tremendous focus on asset management fees and expenses, which is great for investors, but if you’re a consumer of index data—not for creating index-linked products, but for benchmarking—the cost has been going up,” says Sanjay Arya, head of Morningstar Indexes. Under the vendor’s plan, “if people only use indexes for benchmarking, research, to track the markets, or to use Morningstar’s name in client communications and reports, they will have to sign an agreement, but there will be no cost associated with that. The only time we would charge is if someone creates a product—such as an exchange-traded fund—based on one of our indexes. Then, there would be a nominal charge.”

A source at one UK-based asset manager frustrated by rising fees, says the free model could accelerate adoption of new benchmarks. “To my mind, the only benchmarks that have value are those where data is very difficult to obtain. Otherwise, there is so much data available for indexes generally that all index providers can do is charge people if you refer to them in writing—they’re just enforcing their copyright,” he says. “For us, we don’t track indexes—it’s purely a reporting issue, and there are so many things you can report against. Other index providers don’t care—they love the publicity of being attached to investments.”

Euronext will unveil more details of its own free-of-charge index project early in the first quarter of next year, as part of plans to significantly expand its index offering beyond its four key country indexes—the PSI 20, the BEL 20, the AEX, and the CAC 40—to a pan-European and ultimately global index business. 

“There is still high demand for these, but people also want access to broader indexes. There is political uncertainty, and those four country indexes are not broad enough if you’re investing across Europe,” says Michael Hodgson, head of information services at Euronext. “Euronext has a good brand name in its domestic markets, but to make ourselves a bigger index business, we have to be in the entire European index space, rather than just in four countries. And we can’t take on the world if we don’t already own Europe.”

Initiatives such as these will face many hurdles, not least of which is brand recognition. Just as the old saying goes, “No one got fired for buying IBM,” no asset manager is ever asked to justify why they use the FTSE 100 index, Arya says.

Bacon says The Freedom Index has seen traction among smaller asset managers that have no other alternatives, and expects to gain further traction through development of custom indexes over the longer term, but cites brand as a critical factor in gaining traction—one that comes with a cost that investors may be unaware of. “Brand is a major issue. The end user wants to recognize the brand, and it’s not clear to them that they pay for this index brand in higher prices. That’s why increased transparency is good,” he says.

One issue is that it’s not the asset managers that need convincing; it’s the funds and individual investors who are less likely to be aware of a startup provider’s brand and experience than dedicated index and data licensing professionals.

“Morningstar is best known for its fund ratings, where it has a great brand name. It’s certainly a credible player, and the plan sponsors and others in the market will definitely be familiar with it. But the index providers target the asset owners and advisors—it’s like toy makers advertising to kids on TV who then hassle their parents—so that when mandates come in to manage pools of money, there will be pressure to have those brand names attached,” Cheng says. “The advisory boards of funds like state pension plans are typically risk-averse. The individuals are typically part-time, and aren’t necessarily investment experts, so they depend a lot on advisors.”

Here, Morningstar may have an advantage: Not only does it have 15 years’ experience running indexes; its client base already includes 250,000 investment advisors using one or more of the vendor’s products, all of which include its indexes, Arya says.

But while brand recognition has often been cited as a reason for not adopting new providers until now, the economy may see this overridden by more practical concerns: “What we’ve seen from our research over the last couple of months is that brand is important, but cost is more important,” says Euronext’s Hodgson.

Managing Change

Successfully making the case—based on cost or other factors—to switch index providers is only half the battle: You then face the practical challenge of swapping out index data sources. On the face of it, the operational tasks fall into two categories: the licensing of data, and the reallocation of assets. “You probably need the right to switch benchmarks in your prospectus. Typically, benchmark index licenses are annual, so you just have to give notice and make sure the terms are honored,” says Steve Ellenberg, product manager for the Index Licensing Manager product at market data cost and inventory management platform vendor MDSL. “Switching indexes is a transitional process from an operational perspective. For a passive fund, the concern is to make that transition with as little impact on your portfolio—i.e., without moving the components of the new benchmark index as a result of taking positions in them, and without publicizing it because other people will front-run you and move the market before you can place your trades.”

However, Rimes’ Cheng warns that this can turn into a big data management and IT project. “You have to decommission old datafeeds, write feed handlers for new feeds, and integrate them with your risk, performance, and front-office systems,” he says. “So even though the returns might be the same, the cost of moving from one supplier to another could be a six-month or one-year project.”

In addition, buy-side firms may have to bear the cost of supporting multiple benchmarks over the long term to keep different customers happy while providing proof of a free index’s performance. “Large asset managers can’t switch easily and exclusively to a new index. There will be clients that want the old index information, so for many managers it will be very difficult to eliminate the old index—so in the short term they will have the additional costs of the new provider,” says The Freedom Index’s Bacon.

This isn’t lost on those who follow this sector, who warn that incumbency gives firms’ existing suppliers—no matter how unpopular they may be—a distinct advantage over any new entrant trying to unseat them, who must demonstrate compelling reasons why they should displace longer-established and better-known rivals.

In particular, several sources expressed fears that user firms would simply use the free indexes of credible organizations such as Morningstar, Euronext and others as a threat to negotiate better deals from their existing suppliers. As more than one interviewee put it, “I hope they have deep pockets and are prepared for a long game.”

Morningstar’s response: Bring it on. “The metrics of success will be how many people sign up and use the indexes. It won’t happen overnight. But we’re in this for the long haul, and we’re very patient,” Arya says.

Where the Value Is

But that doesn’t mean Morningstar and Euronext are prepared to eat losses in the meantime. Though there’s a cost associated with creating and maintaining indexes, the providers feel that the real opportunities to make money from indexes lie beyond public benchmarks.

Returning to the theme of the economy as a driving factor, now is the time to embark on a fee-free index project “because of the emphasis on cost in the industry, and also because there is less volatility, so people are looking for new products to create, but they see that it’s expensive to create these products because of index costs. There has also been a big rise in passive investment management, and a big rise in smart beta products that try to beat the market, which reflects the general malaise in the equity markets,” Hodgson says. “The standard, vanilla-type indexes that are used to create benchmarks could be available for free. The real value is in the smart beta space—that’s where you can make money.”

Indeed, while making its core indexes available for free, Morningstar will continue to charge for its proprietary smart beta indexes. “We are a publicly traded company and have shareholders, and there is a cost to maintaining indexes. But I think the market is moving more toward strategic beta, and that’s our core competency—we have 300 people across the globe doing security-level and fund-level research. Indexes are a way to work with that research, and to work with exchange-traded fund (ETF) providers and charge fees for them to create products on our indexes,” Arya says.

In addition, there’s an element of up-selling involved with free indexes: Hodgson says Euronext will look at all the fees traditionally associated with indexes—such as for providing real-time index values, constituent weighting data, fees to license indexes to create investment products, and fees to trade those products—and decide which make sense to eliminate, and which to retain, so that the result benefits clients but also still enables the exchange to make money.

Meanwhile, Morningstar will provide month-end constituent data for free, but will charge extra for daily data, which Ellenberg says is essential to keep track of the impact of corporate actions on a stock’s individual weighting in an index, to ensure the index remains balanced. “From broad analysis and discussions with our clients, we feel that for benchmarking purposes, month-end constituent data will meet the needs of Open Indexes Project clients. Morningstar will have daily portfolios available, but they will have a licensing fee associated with them,” a Morningstar spokesperson says.

And while Morningstar and Euronext have both said they’re committed for the long haul, Bacon says the future is always uncertain. “There is always a temptation to charge more when the brand is established. This might not be the initial objective, but you don’t know who the future owners will be, or their motives. That is why The Freedom Index employs the voluntary contribution model and is a company limited by guarantee—which means we can’t distribute profits and we have no share capital,” he says.