The move by Vanguard, the nation's third largest manager of ETFs, to change the benchmark on 22 of its index funds and ETFs earlier this month reverberated throughout the indexing industry, placing it squarely on the battlefield as the pricing war between two of the biggest ETF makers rages on.
Vanguard announced on Oct. 2 that it would move away from index publisher MSCI and instead transfer the 22 Vanguard fund products to established benchmarks run by London-based FTSE Group or to new benchmarks developed by the University of Chicago's Center for Research in Security Prices. The switch, planned for January, involved almost $540 billion in assets, and is estimated to cost MSCI about 2% on its 2013 revenue and 6% on its operating income. The New York-based index firm's stock hit a three-year low, losing almost a quarter of its market value, on the news.
Vanguard did not return requests for comment, and MSCI referred to its Oct. 2 press release on the matter.
Asset holding companies-such as mutual funds, pension plans and endowments-place a tremendous amount of time and effort in selecting and maintaining the relationship with a benchmark company, according to Deborah Fuhr, co-founder and managing partner of ETFGI LLP, a London-based independent research and consultancy firm that focuses on the ETF industry.
"The benchmark relationship is one of an asset owner's most important relationships, as it defines their investment universe, which impacts everything from how the fund is performing, to defining what products can be used and deciding how and where assets can be and are deployed," said Fuhr. "From a retail client point of view, benchmarks have become more similar over the years so the specific benchmark is not as important."
That index companies such as MSCI should become a casualty-or at least receive a severe collateral damage-isn't a surprise to those watching the unfolding pricing war between the two of the biggest ETF companies, BlackRock's iShares and Vanguard. Indeed, Vanguard's move raised further fears that other major mutual-fund and ETF firms could think along the same lines, and push the benchmark industry to cut the prices they charge the mutual-fund industry even lower. (Currently, fees to license an index generally run between 2 and 30 basis points of the fund's assets, annually, depending on the index.)
It was with just this kind of triage mentality that MSCI CEO Henry Fernandez addressed the Vanguard move in an analysts' conference call, saying funds should look at more than price when determining what benchmark or what index firm to go with.
In a Morningstar report on Vanguard's move, analyst Swami Shanmugasundaram expressed worry that a pricing war among fund companies to lower costs to investors, especially in the hugely-popular ETF area, could ignite further pricing-related partner-switching in the indexing industry. "Although the direct fallout from Vanguard's move is significant, it will pale in comparison if other ETF sponsors, BlackRock in particular, decide to follow suit," Shanmugasundaram wrote.
Interestingly, when BlackRock made its big ETF cost-cutting announcement on Oct. 15, it actually reaffirmed its commitment to the MSCI brand. As part of its cost-saving initiatives, iShares launched iShares Core Series, a group of 10 ETFs, cutting the fees on the new funds in the process. All three of the international equity ETFs in the iShares Core Series will track portions of the MSCI Investable Market Index (IMI). In the press release announcing the new initiative, Mark Wiedman, managing director and global head of iShares, singled-out MSCI for praise, saying the index firm "is the predominant choice of professional investors."
BlackRock's news and endorsement of MSCI may have taken the heat off the indexing industry for now. And thus far, other major index providers, such as Russell Indexes and S&P Dow Jones Indices, have not yielded to pricing pressures, instead relying on their market share dominance and well-known brand indices to keep client funds satisfied. In a recent report by ETFGI, the benchmarking industry showed a concentration at the top similar to the ETF industry, with indices from the top three index providers-S&P Dow Jones, MSCI and Barclays Capital-being tracked by ETFs that represented almost 55% of global ETF assets.
Fuhr noted that after the top tier of benchmarking firms, there are literally hundreds of smaller ones below that. "Investors have a preference for certain benchmarks and benchmark companies," said Fuhr, noting that it takes a significant cost investment and a consistent methodology to credibly enter into this crowded field.
In fact, some market observers think Vanguard's change away from a high-quality name such as MSCI simply to lower its overall fund costs was somewhat short-sighted and not likely to begin a wave of similar moves.
"I think the exit of Vanguard from MSCI ushers in the bottom of the market for this pricing pressure on index publishers," said Jim Pacetti, head of business development for index provider S*Network Global Indexes.
Pacetti said it's clear that in making its strategic switch, Vanguard thinks that retail investors care only about price and not about the brand of the index. "But I would argue that the target market for ETFs-the registered advisor crowd-does stick with the index brand they think does the best job and that price is a lesser consideration," he said.
Additionally, dropping MSCI was not without risk-something Vanguard certainly knows. For example, among the 22 funds affected by the move is the Vanguard Emerging Markets ETF (VWO), which will switch to a FTSE index and exit South Korea, shedding such stocks as Hyundai Motors and Samsung. Messing around with a proven winner-over the past five years, VWO has gathered the most ETF assets-may seem foolhardy in such a tightly competitive market.
In fact, the move could create more ripples than Vanguard first envisioned, even if it makes a successful play for more retail investors by lowering costs. For example, losing MSCI means Vanguard is likely to lose some institutional investors, too, since many favor the MSCI benchmarks and could move out of Vanguard ETFs-and into rival BlackRock's ETFs-in order to continue using MSCI indices.
"In a way, I think this is the best thing for BlackRock," said Pacetti.