Open Letter to the industry: The Hidden Tax of Index Data

Open Letter to the industry: The Hidden Tax of Index Data Updated: 7/9/2014

By Justin Wheatley, Chief Executive, StatPro Group

This op-ed was originally published in Inside Market Data on July 7, 2014.

As index use has grown, so have the ways in which entrenched index providers are extracting revenues from licensing their indexes and underlying data. But with cost still a key concern, with the popularity of exchange-traded funds growing, and with incumbents facing fresh competition, the industry may be ripe for change, says StatPro group chief executive Justin Wheatley

It is a remarkable phenomenon how much money is spent these days on index data. Indexes started off as a humble measure of roughly how well a stock market was performing. Today, there are millions of indexes available. Fund management companies must buy the licences to use these indexes to measure their performance, and they pay handsomely for this privilege.

Over the years, index providers have generally become more and more aggressive about how their indexes are licenced, seeking out additional licencing fees for every possible usage. Over the 20 years I have worked in the industry, I have rarely heard anyone that was happy about the cost of their index supply. There is a perception that companies are trapped and forced into paying excessive fees for little perceived value-add, despite the best attempts of index providers to demonstrate how unique and useful their particular indexes are.

To a certain extent, it is puzzling how index providers can charge so much. If a supplier of a product keeps raising its price and enjoys significant net margins (over 80 percent, in some cases), you would expect competition to join the fray and drive down prices to a normal and reasonable level—especially if the product is easy to imitate. Well, indexes are indeed very easy to imitate, and competitors have popped up everywhere, sometimes even offering indexes for free. Yet the leading providers of index services have seen no drop in business—in fact, they have grown even faster. So the success of the incumbents has nothing to do with the uniqueness of their products (some rival indexes have a 99.99 percent correlation with the leading index), but rather something else.

The new market for exchange-traded funds (ETFs) has also been a boon for index providers, as would-be sellers of ETFs have launched numerous funds pegged to indexes. Fund management companies pay significant sums for the right to offer such products as the S&P 500 ETF, the FTSE 100 ETF or the MSCI World ETF, as it helps sell their ETFs better, even though they could easily produce an ETF based on a low-cost index.

Brand Management

So it is evident that the index business is not only about the computation of a benchmark, but is also an exercise in brand management. Fund managers make a lot of money managing other people’s investments. Their top priorities are reputation and trust. By using a recognizable brand name as a benchmark index, they can gain and maintain trust with their clients. This brand effect is the real reason why the leading index providers do so well. It is also noteworthy that some providers are strong in equities and others in bonds. Some are well known for a particular market or region, like emerging markets, but none are used for every type of investment, even though many cover everything. Once an index provider is established as the leader in a given niche, it is hard to unseat them, as they have the trust of the market.

Brand name and trustworthiness are important to retail and institutional investors alike. The institutional investors are the guardians of pension funds and insurers deposits, who parcel out their capital to be managed by different fund managers. They are in turn advised by professional consultants whose job it is to keep the fund managers honest. These consultants want to benchmark the fund managers against indexes to ensure that their performance is up to scratch, and this process has contributed to the growth of indexes.

Say a consultant recommends an index to measure the fund manager. The fund manager has no choice but to use this index and then manage their money relative to this benchmark. Once embedded, this index is nearly impossible to replace, and this in turn allows index providers to raise fees without fear of cancellation. As certain index providers become the “leaders,” it takes a brave consultant to recommend a new, cheaper index provider.

The index world is an entrenched business. The fees of index services are initially paid by the fund managers, but they simply pass the fees on to their clients. So in the end, it is pensioners and investors who pay. Indexes have become a hidden tax.

So, despite this unhappy outlook, it is pleasing then when companies try to break the near-index monopoly that exists. Nasdaq OMX has recently launched a big campaign to provide a new class of global equity indexes that are nearly identical to other famous indexes, but at a fraction of the price. Using its technology, Nasdaq has built an index calculator that can easily create thousands of indexes at a much lower cost than their competitors. Nasdaq also has a world-famous brand, and should leverage this to gain market share.

Another is the Freedom Index, an independent, not-for-profit index provider, set up with the express intent of providing free indexes (it does accept donations, however, and StatPro makes a financial contribution to funding the Freedom Index, and also supplies it with data to compute its indexes), and providing a high-minded attempt to make the incumbents more reasonable. While the Freedom Index is tiny and has no brand to speak of yet, its worthy desire to do the right thing should enable it to gain support easily, and brands are best built through reputation, rather than simply marketing.

Both low-cost alternatives like Nasdaq OMX, and free providers like Freedom Index are expanding their coverage, and plan to one day be major providers of index data. Consultants would be advised to take a look and save their clients and pensioners a packet of money while being every bit as good as any other index provider.

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