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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 20 December, 2012 | 10:06AM

Most exchange-traded funds (ETFs) and exchange-traded products (ETPs) track indices 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 ETP providers for using and tracking their brand-name indices, and then these costs are passed on to ETP investors.

But a shift is now going on in the industry that is seeing some ETP providers opt to create their own indices 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 ETP fees. Stateside, WisdomTree and IndexIQ are self-indexing.

This change has deeply divided the industry.

There are concerns about the transparency of these new 'no-name' indices 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, sub-optimal 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 ETP that tracks a non-branded 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 ETPs, 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 ETP investors to understand the exact costs associated with licensing a particular name-brand index. So ETP 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 indices 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 to a fundamental index provider, such as Research Affiliates. Both types of firms have an interest in showing that their models outperform traditional indices.

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 indices, and they may not necessarily welcome a mismatched ETP 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 indices, rather than the broad market categories.

Regulation of Self-Indexers

The regulatory environment for self-indexing is still murky. In the US, ETF providers must seek exemptive relief from the Securities and Exchange Commission. In Europe there are no specific restrictions on the practise, and in its recently published guidelines for the industry ESMA didn’t propose any restrictions beyond the UCITS Directive’s existing requirements for transparency, diversification, and the need to act in unitholders’ best interests.

As competition intensifies among ETP 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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About Author Alastair Kellett

Alastair Kellett  is an ETF analyst with Morningstar Europe.