Investing Basics: Indices, the drivers of ETF growth

An ETF tracks the performance of its index as closely as possible. But who is behind the indices? After all, your results depend on how their products capture the market – writes Jan Altmann

Indices were not originally designed for the central role they play in portfolio management today. But a glance at their history tells us a great deal about why they have come to rule investors’ outcomes.

The first wave of index innovation occurred as the US emerged as an industrial giant. The fathers of the index were Charles Dow and Edward Jones, the founders of the Wall Street Journal.

Their names have a familiar ring because they’ve been immortalised in the Dow Jones Industrial Average, the US’s second oldest index, and one that’s still calculated today. The original Dow Jones index, the Railroad Average, was launched in 1884 to enable readers to monitor price movements in the booming market for railroad stocks.

After the bubble burst, attention shifted to the wider measure of stock market fortune that became the Dow Jones Industrial Average.

Stock exchanges began to compete with the publishing houses for price information by calculating their own indices at the beginning of the 20th Century.

In London, the two sides came together to create the enduring Financial Times Stock Exchange or FTSE – a joint venture between the Financial Times and the London Stock Exchange.

The idea to benchmark investment management using indices emerged slowly many decades later. This heightened need for accurate calculation of capital market data brought together the global index expertise of Capital International, and the financial muscle of Morgan Stanley to create MSCI in 1986. MSCI now stands as the world’s largest index provider.

Invest the index

 
Index investing is huge today but only circulated as a theory among academics in the 1960s. The first index products didn’t emerge in the US until the 1970s and the idea only gained ground in Europe from the mid-1980s.

No longer did you need an expensive and fallible fund manager, now you could use the wisdom of the market to design your portfolio as captured by the index data.

The increasing prominence of the index naturally proved lucrative for index providers. Their expertise and position as data gatekeepers enabled them to develop a powerful licensing business.

Their brands lent credibility to fledgeling passive investing products: no licence, no index tracker. And as index products exploded in popularity – especially ETFs – licence fees became hugely profitable, especially as they are usually linked to assets under management.

MSCI’s rise since its 2007 floatation mirrors the market shift to index investing. The company reported revenues of $1.3 billion and a staggering $579 million in operating profits in 2017.

Bond indices – another world

 
Most bonds are traded ‘over-the-counter’ (OTC) rather than on public exchanges. Crucially that means most trading occurs between large financial institutions such as investment banks and not on a transparent, central market. That’s why most bond indices are associated with banks – think Citi, JP Morgan or Barclays.

Originally, the banks’ index data and price feeds were made available to their institutional customers as a benchmarking and reporting service. The bond index licensing business came later as demand grew for bond ETFs and index funds.

But the banks headed for the door as the Global Financial Crisis brought stricter (and expensive) regulation in its wake. The Barclays indices switched to Bloomberg in 2015 while the iBoxx indices are calculated by the global information provider, IHS MarkIT.

New players in the index business

 
The demand for new indices to support new passive products has fostered innovation in the index space. Some smaller providers have achieved spectacular success with niche themes such as robotics and cybersecurity, while others differentiate through price.

Solactive charges a fixed fee, for example. Some ETF managers have also cut costs by launching their own indices, especially when their brand is strongly associated with certain investment strategies, for example: WisdomTree (high dividends), VanEck (commodities), and Ossiam (minimum variance).

We’ve summarised the most important index providers at the end of this piece.

Cheaper products with lesser known indices?

Expensive index licensing fees run counter to the cost-cutting philosophy of index investing. ETF providers can pay anything from 0.01% to 0.5% a year to their index licensors. That can make the difference between market-leading and market-trailing when the cheapest ETFs now boast total expense ratios (TER) of 0.02%.

Big brands command big fees which is why you’ll see the likes of Lyxor using lesser known Morningstar indices in a bid to top the charts with their Core ETF range.

Still, the ‘best buy’ charts are dominated by products sporting the major index labels: S&P, FTSE, MSCI and STOXX. Why? Because scale drives cost efficiency. Meanwhile, the scale is driven by trusted strategies with strong brand equity. Thankfully, high index fees have less impact at high volume.

High stakes mean new regulation

 
Not so long ago you could have licensed your own index to an ETF provider using little more than the computing power of your smartphone. But billions now depend on small benchmark movements, creating the temptation to game the system, as revealed by the LIBOR scandal.

This prompted the EU to step in with new regulations for indices which came into force in 2018 and must be fully complied with by 2020. The ESMA Benchmark Regulations stipulate: