There’s plenty of money to be made in index funds — especially for the providers of the actual indexes. That’s according to mutual fund information provider Morningstar, which argues in a new paper that the highly lucrative business of licensing generic equity benchmarks to asset managers is ripe for disruption.
Morningstar says index-licensing fees are rising at a time when asset managers are already facing relentless cost-cutting pressures owing to falling fee income and squeezed margins. What’s more, managers have little choice but to pay the fees.
It’s not just a problem for passive funds. Even active managers need to license benchmarks, as these managers formally compare their own performance to the indexes, listing them in legal documents and for use with consultants.
“Industries dominated by just a few players that benefit from high switching costs tend to exert pricing power,” according to the paper. “Unsurprisingly, index licensing fees have trended upward. Anecdotally, they have risen past the rate of inflation — by some accounts doubling or tripling over a five-year period.” Some asset managers have said benchmarking data is a top-five data expense, according to Morningstar.
Dan Lefkovitz, who works on the index team at Morningstar, says core indexes from Dow Jones and others were originally intended to give newspaper readers a general sense of the market’s direction.
“Indexing is now an investment strategy with billions tracking these benchmarks,” said Lefkovitz in an interview. The largest index providers include S&P Dow Jones Indices, MSCI, FTSE, Russell, and Bloomberg.
“Active managers are compared to the benchmarks,” added Lefkovitz. “That’s big business too.”
To be clear, Morningstar isn’t entirely unbiased. The Chicago research firm operates a sprawling business that includes mutual fund rankings, institutional, and advisory services. It both uses and pays for third-party benchmarks and offers its own. Its open-indexes project offers data for benchmarking purposes from more than 100 global equity indexes for free.
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Although industry information on licensing fees isn’t readily available, a research executive at a large asset manager said index licensing fees have been rising annually. He said only the largest managers can “self-index” and justify the big costs of doing so.
The industry has become more concentrated, exacerbating the issue, according to Morningstar.
“Thanks to mergers and acquisitions, a few providers control the bulk of market share,” the paper’s authors found.
Morningstar pointed out that it’s not easy for asset managers to switch indexes, which are part of the investment objectives of a given fund and embedded in its systems.
Lefkovitz said that he expected more asset managers to follow a move Vanguard Group made in 2012. The index fund giant switched the indexes tracked by 22 of the firm’s index funds and ETFs at the time so it could lower costs.
“We were expecting it would set off a bunch of switching, or at least price comparison,” said Lefkovitz. But that didn’t happen. “Costs are coming down across the board. You have zero cost funds, no trading fees. This is one area where they are going up.”
