With the rapid growth of passive investment, indexes, usually serving as the underlying benchmark for the creation of such funds, are gaining more attention and traction too.
The indexing space is dominated primarily by three companies in the U.S. – MSCI, S&P and FTSE Russell. There are two salient issues with these dominant players.
First, they charge a hefty fee on their customers usually on two counts – one is a flat fee and the other is a sharing fee based on the AuM size of the fund. They have enjoyed a great number of profits due to their position at the very top of this food chain. For example, the SPDR S&P 500 ETF(SPY) has amassed over $250 Billion since the 1993 inception, let’s make a simple hypothetical scenario and put out the math here, even if S&P just asked 1 bps sharing structure, which, very likely won’t be the case, they rake in $250,000, 000, 000 * 0.0001 = $25 million each year without much marginal cost.
Customers such as BlackRock would not, by their business nature, satisfied with this kind of terms forever; hence, they try to integrate vertically upward. They come up with “self-indexing” strategy. Afterall, index creation and calculation is not a rocket science, why can’t one do it themselves? WisdomTree and IndexIQ followed the suite, they hire in-house team containing data scientist, financial professionals to perform self-indexing.
The other issue of these dominant index players is their antiquated approach. As of today, most of them are still following their classical traditional, largely Excel-based approach, relying heavily on a committee of human experts to decide the index composition. However, technology is advancing fast, aiming to disrupt the financial space too. There are small index providers armed with top-notch models to reinvent the index business. Large firms try to catch up, and the best and quickest way is, as always, to acquire start-ups. When the news broke out that S&P acquired Kensho recently with an unprecedented whopping $550 million, I see it a harbinger of more such deals.
Another start-up, Motif, worth some more attention too because it was created to disrupt not only the dominance of big indexers but the entire pre-conceived concept of “institutional indexers”. This website allowed individual investors to form all sorts of combination of securities – basically same as indexes -, and then trade on the basket directly. However, when time goes by, the company “evolved” to become a more or less another ordinary index provider, but they claim to deploy “A systematic, rules-based process results in unique insights and efficiencies”.
In the following, I summarise their main steps to create thematic indexes:
1. Using natural language processing and advanced search algorithms to parse big data and form a thematic universe
2. Calculate theme beta, i.e. a metric of theme exposure in terms of revenue, human capital, deal contracts
3. Armed with a multi-factor risk model and optimizer to calculate the optimal weightings
4. Use a Technology-Managed Model to perform periodic rebalancing and monitoring
Their indexes are widely used in “Goldman Sachs-issued structured products; Separately Managed Accounts(SMAs) at Ascent Capital Management; variable annuities at Global Atlantic.”
SMAs is an alternative to Mutual Funds, provided especially to the wealthy (with a $500,000 minimum per Wealthfront) but not ultra-wealthy clients to give them a high return profile with tax benefits. Index-benched passive investment has gone big for such accounts, and to maximize the benefits for this kind of clients, an extreme form – direct indexing – is getting popular.
What is Direct Indexing? Direct Indexing circumvents the step of ETF unit creation conducted by market makers, instead, the investors purchase each constituent of an index at the exact weight/share to form their portfolio. The major benefit is not just forfeiting the expense charged by ETF issuer, but tax-loss harvest. There are notable intricacies such as full replication or stratified sampling, deletion/addition of securities, weighting shifting etc, but the large asset managers together with brokers are able to offer this kind of special service and it’s well embraced. Vanguard, Schwarb, Goldman Sachs… are jumping on board already.
This phenomenon may not be a good thing for ETF managers but sure is not against the index providers. Whichever route the end customers choose, they need solid indexes as their benchmark or framework.