Self-Indexing: Conflict in the ETF Industry

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.

Opponents also say that having benchmark construction and portfolio management under the same roof may create a conflict because the firm may try to create indexes that are easier to track but are not necessarily in the best interests of investors. Additionally, self-indexing providers may be tempted to choose constituents that are likely to be valuable in the securities-lending market, which could give the firm an additional revenue boost. But these concerns could be effectively mitigated by a firewall between the index maintenance and the portfolio management teams.

There is another concern that a self-indexing fund provider would tamper with the index rules in an attempt to boost performance. Investors should watch for any changes to the methodology of the underlying benchmark, just as investors in actively managed funds must look out for style drift or management changes. But the incentive to tamper would be no worse at a self-indexing firm compared with a fundamental index provider, such as Research Affiliates. Both types of firms have an interest in showing that their models outperform more-traditional indexes.

Will Self-Indexing Benefit Investors?
A big question is whether self-indexing can really deliver the benefits its proponents tout. At first blush, cutting out the middle man sounds like a promising road to cost savings. But the creation and ongoing maintenance of an index within a separate business division requires additional resources, so the provider would have to have sufficient scale to make it cost-effective. Not to mention the fact that the index providers currently shoulder a good deal of the marketing and branding that attracts investors.

The demand for these products is also unclear. Institutional investors are often benchmarked against the large, well-known indexes, and they may not necessarily welcome a mismatched ETF within the passive component of their portfolios. For them, it would add career risk. That said, there may be more demand within niche corners of the market, and in strategy indexes, rather than the broad market categories.

Regulation of Self-Indexers
The regulatory environment for self-indexing is still murky. In the U.S., ETF providers must seek exemptive relief from the Securities and Exchange Commission. In Europe, there are no specific restrictions on the practice, and, in its recently published guidelines for the industry, the European Securities and Markets Authority didn’t propose any restrictions beyond the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive’s existing requirements for transparency, diversification, and the need to act in unitholders’ best interests.

As competition intensifies among ETF providers, it is inevitable that there will be a temptation to look more closely at index licensing fees, which are typically tied to assets under management, as a cost-cutting opportunity. In practice, the benefits of self-indexing are perhaps not as significant as they first appear, but neither are the risks as grave.

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Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.