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Self-Indexing: Conflict in the ETF Industry

Some ETF providers are going to great lengths to avoid index middlemen, which is causing concerns about a conflict of interest.

Alastair Kellett, 12/26/2012

Most exchange-traded funds track indexes that are compiled by well-known industry names such as S&P and MSCI. These popular benchmark providers are able to charge relatively high fees to ETF providers for using and tracking their brand-name indexes, and then these costs are passed on to ETF investors.

But a shift is now going on in the industry that is seeing some ETF providers opting to create their own indexes to avoid paying fees to benchmark providers. This has been dubbed "self-indexing." In theory, cost savings from this move can then be passed on to investors in the form of lower annual ETF fees.

In the United States, WisdomTree and IndexIQ are self-indexing. This change has deeply divided the industry.

There are concerns about the transparency of these new "no-name" indexes and concerns over potential conflicts of interests. In particular, opponents to self-indexing cite potential problems around the pricing of index constituents, the embedding of poorly disclosed costs, suboptimal index construction methodology, and incentives to tweak the index rules to boost performance.

Advocates of self-indexing see it as a way to offer investors lower fees, provided they're willing to accept an ETF that tracks a nonbranded index.

In many instances, both sides may be overstating their case.

Conflicts With Self-Indexing
Constituent pricing is perhaps the most blatant conflict. Particularly for funds with less-liquid securities, there is often some discretion involved in coming up with a precise calculation of net asset value, which has a direct impact on performance. For self-indexed ETFs, it makes sense to have an independent third party calculating the pricing on the index, just as it makes sense to have third-party pricing in actively managed funds.

Worries over poorly disclosed costs being embedded within the index fall somewhat flat. At present, it's generally very difficult for ETF investors to understand the exact costs associated with licensing a particular name-brand index. So, ETF investors would be no worse off with a self-indexing process in terms of fee transparency.

Al Kellett is an ETF analyst with Morningstar Europe.

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