Taking center stage

Low costs have always been one of the biggest attractions of exchange-traded funds, so it should put a smile on advisers' faces to learn that the largest providers of ETFs are squaring off with index providers to lower costs. Experts predict that any cost cuts will make their way down to the end user. Indexes and exchange-traded funds have always had a symbiotic relationship. All but a small sliver of the $1.42 trillion ETF market tracks an index, after all. Those indexes, created and maintained by companies such as Standard and Poor's, MSCI Inc. and FTSE Group, were important in the early days of the ETF industry because they were the brands with which investors were most familiar. But signs indicate that reliance on brand-name indexes to attract investors may be waning in a new era of brand-name ETFs. “The value is changing,” Mark Wiedman, global head of BlackRock Inc.'s iShares unit, the largest ETF provider, said at an industry conference last month. A decade ago, ETF brands were weak and index brands were valuable, but that isn't necessarily the case anymore, and that gives ETFs more bargaining power, he said.

"A GOOD THING'

“If they can use their scale to bring costs down, that's a good thing for investors,” said Todd Rosenbluth, director of ETF research at S&P Capital IQ. “It's a bad thing for index providers.” The Vanguard Group Inc. was the first ETF company to play hardball with index providers. Last fall, Vanguard, architect of the first index mutual fund, dropped MSCI as the index provider for 22 of its ETFs. The reason for the switch was that MSCI was charging Vanguard a percentage of assets under management. Under that arrangement, which is the standard, the costs of licensing the MSCI indexes grew along with the fund's assets, preventing Vanguard from using its growing scale to lower the end costs for investors. Vanguard replaced MSCI with FTSE and the relatively unknown University of Chicago Center for Research in Security Prices, both of which are now being paid a flat fee that Vanguard expects will allow it to lower costs on the ETFs. The impact of the new indexes on the ETFs' expenses won't be known until the funds have had a full year of operation under the new agreement. Most telling about the change was the lack of reaction from investors when the ETFs switched to tracking the CRSP. The $28 billion Vanguard Total Stock Market ETF (VTI), the largest of the ETFs that swapped out an MSCI index for a CRSP one, had almost $3 billion in inflows between November and March. Clearly, investors are not fleeing for the exits. The biggest reaction was felt by MSCI. On the day the index changes were announced, its stock price fell to $28, from $36, a drop of more than 20%. MSCI was not available for comment.

BETTER DEALS

That steep decline should provide leverage for other providers to strike better deals, said Ben Johnson, director of passive fund research at Morningstar Inc. A better deal is exactly what Mr. Wiedman had on his mind when he spoke at the IndexUniverse InsideETFs Conference in February. He told the audience, which included a range of executives from asset management and index firms, that BlackRock is reviewing all its licensing contracts. “Nothing is imminent, but it's something we're looking at and will continue to look at,” he said. One of the biggest reasons index providers have lost the upper hand in negotiations is that as the industry has matured, most indexes have adopted the same best practices, making the difference between rivals negligible. “There's been a lot of harmonization and convergence in terms of basic index construction,” Mr. Johnson said. “Indexes are increasingly becoming commoditized. Providers don't want to pay any more than they have to.” Some asset management firms have taken to building their own indexes on which to base exchange-traded funds. Northern Trust Corp., for example, recently launched three dividend-focused ETFs based on proprietary benchmarks. WisdomTree Investments Inc. and Van Eck Global are two other prominent firms that use self-constructed indexes.

NO REVENUE SHARING

“If you're in a traditional arrangement [with an index provider], there's usually some sort of revenue sharing. If you're a self-indexer, you won't have that variable cost,” said Shundrawn Thomas, chief executive of Northern Trust's FlexShares ETFs. “If you can do it at scale in a cost-effective way, there could be net benefits.” The index providers aren't unaware of the position they're in, and are working to get their brands back to the forefront. “We want to establish that there's value in the S&P Dow Jones brand,” said Craig Lazzara, head of index investment strategy at S&P Dow Jones Indices.