A new study is shedding light on just how much power index providers have in the ETF space, in part suggesting that as much as 60% of what ETF issuers pay to them are markups. It also estimates that about a third of what investors pay in expense ratios go back to the index provider.
VettaFi contributor Dan Mika spoke with Yu An, a finance professor at Johns Hopkins University and co-author on the study, about what his findings mean for investors and financial advisors.
Editor’s note: VettaFi maintains several indexes that underlie ETFs. The following transcript has been edited for clarity.
Dan Mika, VettaFi: What inspired you and your co-authors to research what effects index licensing fees have on ETF expense ratios?
An: If you look at the largest ETF in the world, it’s clearly the SPDR S&P 500 ETF Trust (SPY ). If you look at the fee that they charge investors, it’s 9 basis points to investors every year… We find out through news articles that a third of those 9 basis points are paid to S&P for tracking their index, using their intellectual property. And then we just do some simple math. This thing has [more than] $400 billion of assets under management. That’s like $100 million a year just for the sake of computing averages of company prices. This is what motivated us.
Then we started to collect more data, trying to look at if it really is special. S&P has been around for 100 years. It’s the first to ever calculate an index, so it may have some market power and others don’t… We tried to dig into the data, through models, to try and see how much market power the index providers have and how much that is hurting the customer.
ETF Providers & Index Providers
VettaFi: Talk a little bit about what your research says about the current relationship between ETF providers and the index providers.
An: When people talk about the big asset managers like Vanguard, BlackRock, State Street, we talk about them having a lot of market share. If you look at the guys who are actually providing indexes, the market is even more concentrated than the concentration that you see among the big asset managers.
For example, we talk about the “Big Three” asset managers. Within the space of U.S. equity ETFs, really you’re talking about one [index provider]: S&P. In terms of total assets, that company alone has over 50% of the market share. And if you count the top five [index providers], they have over 95% of all the market share. This is a very oligopolistic market we’re talking about here.
What ends up happening is the relationships between these large index providers and the large ETF providers — they are not making one-off choices… On one hand, this is beneficial because they can design indexes that cater more to investor demands. But on the other hand, you can imagine that once you have these very long-term relationships, it is very hard for new players to enter the market. And even if I want to switch indexes, there’s a very high cost of switching and potentially gives the guys in the existing relationship a lot of market power in terms of charging prices.
Index Fees a Growing Percentage of ETF Expense Ratios
VettaFi: Among the funds that disclose the licensing fees, the percentage of AUM fees that are being charged to license indexes rose from 31.4% in 2010 to 35.7% in 2019. Over this past decade, we’ve seen ETFs accumulate massive assets. But we’re also seeing fee wars between ETF providers that push expense ratios down. What do you think all these dynamics mean for ETF issuers?
An: Over [the last 10 years], the ratio of the licensing fee over the total ETF expense ratio has increased from 30% to 35% … If you look at the data, it’s not because the license fees have increased; it is actually because of the acceleration of ETFs. And the ETF expense ratios have gone down.
If you’re working with a standard bargaining model, you would presume the licensing fees should also go down. But there’s a lot of problems. Index licensings [are often] a very long-term contract. Some of them have 10-year life spans.
Even if ETF providers are seeing the pressures to lower their expense ratios for investors, they cannot lower much further. That’s literally their marginal cost. Think about SPY. The ETF cannot lower anything below 3 basis points; otherwise, it would just be doing a charity. The licensing fee has not gone down as fast as the expense ratios, and that’s truly creating the problem. A large part of [what] our paper is trying to say is if we want further decreases to ETF expense ratios to further benefit ETF investors, this is part of the cause. This is what we call double marginalization, and you have to somehow deal with this problem.
ETF issuers presumably already try their best to lower the cost, but there’s a lower bound. If you can lower that bound, there’s a lot to be gained there.
Modeling Competition Among Index Providers
VettaFi: You modeled what would happen if a new index provider were to enter the market. You found that it wouldn’t have a lot of effect on index license pricing. Explain a little more about that conclusion.
An: It’s a little counterintuitive, right? The usual thinking is that if you have a market that’s not very competitive and then you have a new guy coming in, it will make the market more competitive. In the model, the market is already so uncompetitive that one new player [will not] create competition.
You have five index providers and those are established. Those guys are really not competing. So we added a new guy which presumably is on equal footing or even a little bit worse than the existing five providers. So if the five established providers are not competing, what’s the marginal benefit of adding the sixth? Probably not much.
This is actually a famous paradox. It was first discovered by people researching the U.S. cereal market. They found the same thing. You get big players competing and you would think having a new entry will actually increase competition. It does not.
We also have a case with Morningstar, which had a large reputation in terms of retail investors and their famous ratings. [In 2016], it launched an open index project. They provided these indexes for very cheap, and presumably everyone could use them. They tried to be the new entrant to the market. But if you look at the data, they’re really not getting much traction.
I think a lot of that is coming from investors. When they choose ETFs, they see the S&P’s name out there. You associate [that] with trust, and that is something that has been built. It’s very hard for new entrants to replicate that.
Future of Index Competition
VettaFi: What do you think the future holds for index competition? What has to happen in order to create competition that would create downward pressure on the fees that index providers charge?
An: I think in the past few years, things are going in the right direction. First, this is gaining a lot of attention from both the U.S. regulators and also from the European regulators. They’ve been looking into these problems and the potential of these [index providers] charging too much given the rise of passive investing. We’re only looking at the U.S. ETF industry [but it isn’t just an ETF issue]. All the mutual funds buy indexes. Basically any that says it tracks the S&P has to pay for it. You cannot just use that name in your investment vehicle for free.
What is really the problem is that people are not understanding [how much index fees are]. A lot of people we talk to about this say, “Wow, those people are charging a lot.” They are surprised by the sheer amount they’re charging. And it’s also coming from the fact that this data is not that available.
More Transparency Needed
Our paper looks at all the ETF prospectuses. And only about 10% of ETFs, including the large ones, disclose their licensing fees and how they pay it. Most ETFs do not disclose that because the SEC does not require them to disclose that. I think the first step towards thinking about what policies or what else we can do to make this market more clear is first to understand the current status of the market.
I think the calls from various parties, from the researcher side, or from the policy side, have been growing for better transparency. Because at the end of day, if you see this as a double marginalization, it’s likely to be paid by the end investor. So investors should at least know that if they pay that amount of basis points, that they know how much of that is going to S&P…
When people have that data, then they can do better models… and you can see the problem, have a better understanding about what’s driving it. You can then realize how uncompetitive this market is, think of something to cure what is driving this potential competitiveness, and then potentially think about regulations. Those regulations could be limits on fees, or maybe in terms of how contracts can be structured. But that’s all down the road, assuming people can understand why this market is having a problem.
Takeaways for End Users
VettaFi: What do you think are the takeaways for investors and financial advisors from this research when making investment decisions?
An: I think for ordinary investors, there’s very little you can do. At the end of the day, you are not seeing the different combination of what fractions of what I’m paying to the ETF sponsor and what I’m paying the index provider. All you know is the total fee. And then you’re trying to decide over different ETFs. It’s just knowing that when you are paying, you are not just paying your ETF issuers.
On the other hand, you can see a lot of what’s happening here is between index providers and ETF issuers. When they are trying to bargain, when they are trying to write contracts, this is actually getting a lot more complicated. If you look at recent years, there are more [reports of] the new contracts for index providers having breakpoint features.
For example, if you have an ETF with assets under management of less than $50 million, then it’s charged 9 basis points. But if your ETF gets too huge, then we’re going to try something lower like 8 basis points, 7 basis points. This acknowledges the fact that the cost of providing an index does not scale linearly with how much assets are under management.
Going back probably 10 years ago, very few people would have predicted that we would see so much growth in passive investments. It may [have made] sense 10 years ago given the AUM. But now it doesn’t make sense given the huge ballooning assets we have. This negotiation should be happening, and [once it happens, savings] should be passed on towards the end investors. If those savings aren’t passed down, that’s a problem that investors need to worry about.
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