At the start of the new year, the Nasdaq Stock Market announced its second acquisition of a smart beta index provider. Nasdaq will pay $225 million to acquire a name that many registered investment advisers will recognize: technical analysis research firm Dorsey, Wright & Associates (DWA) of Richmond, Virginia.
Index licensing is a highly competitive business with about 140 providers worldwide, says Deborah Fuhr, managing partner at ETFGI, a London-based research and consulting firm specializing in exchange-traded funds and products. But it’s also a lucrative industry that offers plenty of synergies for the exchanges. Nasdaq isn’t the only one that has been making acquisitions, Fuhr notes. In December the London Stock Exchange Group, which sponsors the FTSE indexes, closed its $2.7 billion purchase of Seattle-based Frank Russell Co.; the exchange has said that this deal will boost its index licensing and ETF operations.
DWA co-founder Tom Dorsey won fame in certain circles for the zeal with which he adopted and promoted point and figure charting, a more than 100-year-old method of technical analysis that measures demand for a company’s shares in the market versus the available supply. Developed by Dow Jones & Co. co-founder Charles Dow, it allows investors to see whether the trend in a stock’s price is up or down based on which is greater, demand or supply. If both are in balance, a stock should move sideways.
Dorsey “dusted that science off, and with the advent of technology, has done great things with it,” says longtime acquaintance Joseph Rizzello, chairman of Creative Financial Group, a Newtown Square, Pennsylvania–based RIA with about $450 million in assets under management.
Point and figure charting used to be a tedious process that involved entering daily closing prices by hand in columns of Xs (rising prices) and Os (declining prices). By computerizing that task, Dorsey has been able to expand his technical analysis capabilities to the point where “most of Wall Street outsources their technical research to Dorsey, Wright,” Rizzello says.
DWA is also well known for what it calls its relative strength models, which compare the market performance of stocks individually or in groups. Starting in 2007, Invesco adopted that methodology to build what has become the Atlanta-based firm’s series of 15 PowerShares DWA Momentum exchange-traded funds, which track the Dorsey Wright Technical Leaders indexes.
Last year First Trust Advisors of Wheaton, Illinois, used the same relative strength approach to launch two new sector rotation ETFs. They include the First Trust Dorsey Wright Focus 5 ETF (FV), the No. 1 U.S. ETF launch of 2014, with $1.3 billion in assets.
Most indexes that track the stock market are weighted based on market capitalization. The term smart beta has come into vogue to describe a new category of ETFs that follow indexes designed in favor of factors other than market cap, in the quest for greater returns. They’re still passively managed because once the rules of the new index are established, the ETF must follow those rules, with no human intervention.
“All that smart beta means is that it’s rules-based,” Dorsey tells Institutional Investor. “You have rules, and you let the rules run. It’s not that the beta is smart. If you’ve got bad rules and they suck, your results are going to suck.”
Adding DWA’s 17 ETFs to the 69 that currently license one of Nasdaq’s smart beta indexes will give the exchange nearly $45 billion in assets benchmarked to such indexes out of a total of more than $105 billion benchmarked to all of Nasdaq’s indexes, the exchange said in an announcement.
Most of Nasdaq’s smart beta indexes focus on dividend and fixed-income strategies because of the firm’s October 2012 acquisition of the Dividend Achievers indexes from Mergent. Those dividend-focused benchmarks are used by a number of major ETFs such as the $25.4 billion Vanguard Dividend Appreciation ETF (VIG), which follows the rebranded Nasdaq US Dividend Achievers Select index.
Nasdaq “leveraged Mergent’s technology to create the fixed-income indexes, but we created them ourselves — the BulletShares indexes,” says president of global capital access, technology and insights Adena Friedman. Nasdaq now lists 28 BulletShares indexes, 18 of which are being licensed to New York–based Guggenheim Investments, which has used them as the benchmarks for a series of bond ETFs.
When Nasdaq acquired Mergent’s indexing business, the Fort Mill, South Carolina–based firm had licensing deals with eight ETFs representing a collective $13.9 billion in assets. From that base, the assets tied to the purchase have grown to 44 ETFs managing a combined $33.1 billion as of December 31, a Nasdaq spokesman says. “The Mergent acquisition overachieved on its growth targets,” said Stephen Ellis, a Chicago-based analyst with Morningstar, in a research note.
There’s so much interest in growing the indexing sector because it’s very scalable and profitable at a time when the exchanges are all trying to diversify away from the tightly squeezed transaction business, says Niamh Alexander, a New York–based analyst at research firm Keefe, Bruyette & Woods.
Indexing is part of Nasdaq’s information services segment, which also includes market data, a very profitable division with an operating margin of 72 percent during the third quarter of 2014. According to a company spokesman, the margin on the indexing side of that business is about 65 percent.
In its announcement, Nasdaq said it would facilitate DWA’s international expansion, starting with Canada and Europe. “The cool part about being with the Nasdaq is that it really opens up the world to us,” Dorsey said by e-mail. “We’re a global company on a smaller basis; they’re global on a big basis.”
The Nasdaq announcement also said that by combining forces with DWA, it expected to launch “new products in more asset classes, including fixed income, currencies, and commodities.”
Friedman says Nasdaq will take DWA’s web-based analytical tools for financial advisers and see if they can be expanded to “maybe include some other smart beta models,” and try to “accelerate the distribution of the tools to more people.”
Nasdaq has been in the index-licensing game for a long time, most notably with its Nasdaq 100 index, which includes the 100 largest nonfinancial companies listed on the exchange and is traded via the $39.3 billion PowerShares QQQ Trust Series 1 ETF (QQQ). The firm has developed a number of indexes in other areas, including commodities and the green economy. But “where we have decided to become a major player is in smart beta,” Friedman says.
And for good reason: It’s the fastest-growing segment in the ETF industry, says ETFGI’s Fuhr. A recent survey by her firm showed that worldwide over the past year, the smart beta category of equity ETFs had expanded by 27.8 percent, versus 14.2 percent for the more traditional market-cap-weighted ETFs. “Many active managers are not beating their benchmarks,” Fuhr notes.
Therefore, many investors are looking for strategies that can “systemically” deliver returns that are “better than market cap returns,” Fuhr says, adding that with the addition of DWA’s assets, Nasdaq will move up one spot to become the seventh-largest provider of indexes to ETF and ETP providers globally.
In 2011, DWA sold a 65 percent interest to Falfurrias Capital Partners of Charlotte, North Carolina, because Watson Wright — the low-profile partner — wanted to retire, Dorsey says. Falfurrias, Dorsey and several other key executives have sold their stakes to Nasdaq, which will own 100 percent of DWA. But Dorsey has no plans to stop working at the firm, which will remain at its current location. “I’ll come in a couple of days a week, and then work out of my family office consulting for DWA and Nasdaq,” the 67-year-old wrote.
