Indices are all about money, it is the business of translating market performance into recognisable benchmarks, and making money out of doing the translation. While there are many well-known index brands, like Hang Seng Indexes, Nikkei and Wilshire, the global big 3 are FTSE Russell, MSCI and S&P Dow Jones, plus little brother, Deutsche Börse’s Stoxx which possesses a strong European franchise.
These are very successful businesses, for the big 3½ their combined revenues in 2019 totalled US$2,860 Million up an impressive 51% on 2016. During this period, MSCI Indices averaged a pre-tax margin of 72%, and S&P DJI achieved 67% (including partner shares).
Even more remarkable is the index business, especially when combined with analytics has consistently outperformed their overall group companies, and if were standalone businesses based on a percentage of revenue/group market capitalisation their notional valuation would be US$35,148 Billion as of 13/04/2019. The question is how have they achieved such success?
As I have argued before, index creators and even more so individual indices have become ‘Brands’. A DJIA, S&P500, FTSE 100, Nikkei 225, MSCI Global can be replicated but not replaced. It is arguable that competition is limited in financial markets because key indicators are effectively monopoly products, and financial institutions find it easier to sell products linked to specific brands, not indices the market fails to recognise.
This creates a ‘Virgin Cola’ barrier to entry where even a well known entrant cannot compete with established Coke and Pepsi.
From 2016 to 2019 the index creators revenue growth has been consistent and similar, Stoxx (66%), FTSE Russell (59%), MSCI (50%) and S&PDJI (44%), with the Big 3 linked Assets Under Management totalling US$40 Trillion equal to 60% of IPE’s researched Top 400 Global Asset Managers AUM of US$66 Trillion in 2019.
All the index creators have employed a 2 prong strategy each being a trident, a business led strategy and an index led strategy.
- Grow the market, especially via AUM driven revenues with the number of passive funds recently exceeding active funds by both volume and value
2. Add value driven analytics. Rather than developing inhouse the preference is to buy expertise and established products with an existing client base, killing 2 birds with 1 stone
3. Ruthless compliance. A no prisoners approach to any out of contract usage, accidental or otherwise
Index (Product) led:
- Create new indices out of old, i.e. Thematic & sustainability. Re-packaging indices to meet specific investing parameters, like Environmental, Social & Governance (ESG)
2. New instruments i.e. Exchange Traded Funds (ETFs) which create new classes of security requiring benchmarking
3. Cover a wider range of asset classes, Fixed Income, Commodities, Energy, & Alternative Asset Classes
POTENTIAL FOR COMPLACENCY
As it currently stands there appears to be little systemic threat to the underlying businesses of the leading index creators. They can rely upon 3 influencing factors which work in their favour.
- The business is so high margin, the index creators will be able to weather the current storm, and wait until calm returns. Even a significant drop in revenue potentially caused by a collapse in AUM would be mitigated by the high profit margins currently earnt
- Without major regulatory change, the index creators clients will still be locked closely to their benchmark providers, changing index providers is hard work on many levels
- Barriers to entry are high.
• The Big 3 have brand awareness and global presence
• Equally the regulatory framework for creating indices for commercial purposes is clear and concise but onerous. It is why the Banks dropped their indices.
• The expertise available to create indices, associated methodologies, then implement as a business is expensive and not readily available •Establishing competition in the post-IOSCO principles world is time consuming to build critical mass except in niche markets. This favours incumbents
The notion that it is easy to create an Index is fanciful.
Even without the current Coronavirus pandemic which is having a terrible impact on economic activity, the index creators are facing 4 immediate challenges which come from both ends of their relationship spectrum
1. Clients are increasingly dis-satisfied with the cost of subscriptions, and lack of transparency in how the index creators pricing models function. Quiescence is being replaced by restlessness. Client willingness to pushback is there, but grounded in the reality that changing from one index creator to another does not solve the problem
2. Regulators are interested in costs and quality, especially if it has a negative effect on the costs of pensions and funds
3. Data sources, primarily exchanges, are now becoming aware of how little they are paid by the index creators to use their data, and how much profit the index creators are able to make from the sources’ data. Some exchanges have considered linking fees to AUMs, though the inherent problems have prevented a trigger being pulled
4. Often competition may not seem like a threat because it is small and then suddenly emerges, the big index creators are facing two levels of competition
• Small new index providers which have not adopted the AUM model, such as, INDXX, ScientificBeta, and Solactive
• Self-indexing, which has been embraced by the likes of Blackrock, Charles Schwab, State Street, and Vanguard
• The importance of these 2 levels of competition is the battleground is not in the field of existing benchmarks, but in areas where ‘brands’ have yet to be established, such as ESG and OTC markets
There is trouble ahead and the index creators will have to make compromises, however unwillingly, but their business models are sound, if not liked, and the future for benchmarks looks bright as new markets open up, especially in OTC markets.