This week I thought I’d let readers in on a little secret: Running index firms is a fantastically lucrative business. Now, I suspect that the world-weary among you will tell me you already knew that. But I think you have probably not realized just how lucrative this business really is and why it might get even more so because of our friends, the regulators.
Let me start by taking you on an adventure through some hard numbers.
S&P Global’s index division may only account for around 15% of total revenues at the fintech giant, but boy what a business it is. In 2020 it generated just under $1 billion in revenues and an operating profit of $666m. Some $4.2tn is invested in products tied to the company’s indices, with $2tn in ETFs. If I were a corporate financier I’d be knocking on S&P Global’s door and suggesting they spin off the index business into a fantastic Spac (special purpose acquistion company) – I don’t see any reasons why this one business couldn’t be worth 50 times earnings.
MSCI’s reports are also illuminating. It’s a much cleaner index-led business model, with this part of the business dominating revenues at around $1bn (of which ESG product lines generate $121m in fees alone), with operating margins near 60%. In total there is around $1.2 trillion in assets related to ETFs.
I want the reader to dwell on these numbers because it’s a reminder that despite all the waffle about basis point fees of ETFs heading closer to zero for large ETFs, the reality is rather different. Running an ETF issuance firm might be becoming more challenging – but for the big index firms, the opposite is true. And arguably it is getting more and more profitable, with most of the big players predicting revenue growth of 10% to 12%, and earnings growth even higher than that.
Why might prospects be improving for index firms? First off, because if we look down the list of top 100 ETFs by assets under management, with one notable exception, we see a market dominated by a closely-held grouping of S&P Global, MSCI, Nasdaq, FTSE Russell and the odd Bloomberg Barclays fixed income ETF. That one exception is Vanguard, which has gamely decided to track major asset classes using Chicago Booth CRSP indices, presumably at a small fraction of the cost.
There is a wider discussion among economists at the moment that despite decades of supposedly proactive competition enforcement, huge swathes of corporate America are actually dominated by a handful of oligopolistic players. That’s fantastic news for investors looking for quality, high-margin, wide-moat businesses, but less good news for the rest of us. I would suggest that the index business ticks most quality boxes, all for largely sensible reasons. It’s a game about brand, respectability, and in-house research and number-crunching expertise. I’m not blaming the ETF issuers, or even the buyers of ETFs – you, reader – because you probably need to explain to someone less financially literate than yourself why you’ve bought an ETF by a no-name index firm. ‘What the hell’s wrong with an S&P 500 tracker, Dave?’
But there are other factors at work. One is that as ETF buyers become more discriminating, they’re also demanding expertise around stuff like alternatives, thematics and ESG. At one stage I thought this would be an opening for independent index firms to break in and grab business – especially in ESG-land. But guess what happened? The index firms simply bought the smart new talent and incorporated it into their offering, starting with Kensho (for thematics) by S&P and then carrying on with Sustainanlytics (Morningstar) or Carbon Data (MSCI). Now these firms are sitting at a profitable juncture. As investors swarm into this space, they are seeking high-level brand validation for contrasting ESG data sets, which, of course, helps the large incumbent players.
Looming on the horizon, though, is another tailwind: the potential for regulation here in the US. A recent paper by two academics argues that many next-generation (bespoke and custom) indices are in effect a surrogate form of investment management, but without the usual investment management regulatory permissions. On this score it’s well worth reading a paper handily entitled ‘Advisers by Another Name’ by Paul Mahoney of the University of Virginia School of Law and Adriana Robertson at the University of Toronto Faculty of Law.
The money line in their cogently argued paper is that it is increasingly obvious that as indices become more actively constructed – think bespoke or custom – they need a more active regulatory approach. 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 adviser.’
Index providers who maintain more generic, off-the-shelf universal indices, by contrast, should be able to benefit from what the authors suggest is ‘a conditional, non-exclusive safe harbor which would deem them not to be investment advisers… In order to benefit from this safe harbor, index providers would be required to abide by certain disclosure obligations.’
This is all sensible stuff, but I’d suggest it might have an unintended result: it will concentrate power in the small number of existing dominant players, who will have the financial and lobbying power to manage a more intrusive regulatory regime.
Another way of understanding the same process involves casting your mind back to the various scandals around the Libor interest rate benchmark. Knowledge of these ‘bad practices’ had been kicking around for an absolute age, and plenty of academics had picked up on the abuses before the regulators caught on. You can see the concerns outlined in a 2013 paper called ‘Index Theory: The Law, Promise and Failure of Financial Indices’ by Gabriel Rauterberg and Andrew Versteint, which concluded that Libor was flawed, in part because no one was doing a thorough enough job of owning the index and then protecting it against abuses. The academics suggested there was an ‘irreducible subjectivity built into index production. This subjectivity, which is a key component of indices’ value to users, also carries the potential for manipulation and malproduction.’
They argued that one of the best ways of protecting these indices was, counterintuitively, to increase ‘present index providers’ intellectual property protections,’ meaning giving index owners even greater control over the intellectual property.
And in that last point there’s the germ of real insight. As indices become more central to investment outcomes, they will prompt more complaints about abuses and bad practice. That, in turn, will result in the regulators wanting to blame someone, which means the index firms will need more, rather than less, protection for their rights so they can provide a proper chain of paperwork to nosy regulators. All of which deepens the power of the brand name firms.
So, dear reader, in your capacity as a buyer of said index products via ETFs, what might we propose as remedies to this growing concentration of power in index firms? I would offer three practical ideas I believe we can all get behind. The first comes from the initial academic paper I quoted above, which suggests something of a ‘no-brainer’ reform: if index firms benefit from the safe harbor regulatory exemption, then they might need to disclose fees to the end investor. I think we all need much greater transparency around the cost of these increasingly custom index services.
Related to this is a more practical suggestion – every index should not only have a very clear, investor-friendly ‘explainer’ document, but also a clear name and email address for an index owner who can explain to advisors the thinking behind an index. In plain English.
I would also encourage advisers to build on Vanguard’s embrace 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 either generic versions of indices at low or even zero cost, as well as encourage innovative researchers to develop new bespoke indices that will solve complex investment problems.