Index fees fatigue: Regulators, startups move in on the big 3 providers’ $5 billion business

The index industry has long been dominated by three providers: S&P Dow Jones Indices, MSCI, and FTSE Russell.

In 2020, these companies made up 70% of global index industry revenues valued at $4.1 billion. In 2021, revenues increased to $5 billion, according to Burton-Taylor International Consulting. The big three make, on average, profit margins of 70% to 80%, a figure that has caught the eye of regulators, particularly the UK’s Financial Conduct Authority (FCA).

In March 2020, the FCA began extensive research into the supply and use of data in wholesale markets. The latest installment of its work, a 25-page terms of reference document, highlighted competition concerns it intends to explore in a new market study, which covers benchmarks, credit ratings data, and market data vendor services.

Among these concerns are six themes it will explore, including barriers to entry and expansion, network effects, vertical integration, suppliers’ commercial practices, the behavior of data users, and incentives for innovation. The FCA will make a provisional decision on whether it will open a market investigation in reference to the UK’s Competition and Markets Authority (CMA) about one or more of these markets by September 2023. It aims to publish its market study report by March 2024.

Market data consumers have long complained about the lack of competition among index providers and the fees they command. These are the issues that newer benchmark providers like Solactive, Indxx, MerQube, and CTD Indices (CTDI) aim to solve, but it isn’t exactly a walk in the park.

The work the FCA is doing could push the envelope for these newcomers and provide some form of relief for consumers. But the industry will have to wait to see if the FCA will introduce guidelines or regulations that will shake up the status quo.

“If I was the FCA, I think really, the biggest problem is a lack of transparency on fees,” says Keiren Harris, founder of Hong Kong-based market data strategy consultancy DataCompliance.

Show me the money

A significant source of revenue for the big index providers is tied to assets under management (AUM). WatersTechnology sources have suggested that the biggest asset management firms all write a $100 million check to each of the big three index providers every year. Funds offering an investment product tracking a particular index will have to pay the provider a percentage of the value of the assets. But there are also other ways to monetize benchmarks.

Sources have told WatersTechnology that some asset managers are paying as many as seven times for the same piece of data, including for the use of the benchmark in a fund, for the IP, to receive it in real time on a data terminal, to receive the end-of-day file of the index constituents, and to receive a calendar of changes that will be made to the index.

According to April Kabahar, global head of communications and a spokesperson for S&P Dow Jones Indices, the firm’s pricing arrangements are “aligned” with its customers’ and partners’ interests and success.

“Our fee structures depend on our customers’ objectives and the specific types of product requirements and licensing agreements they are seeking. These fee structures are communicated clearly and transparently to our customers who understand how they work. S&P DJI’s established and trusted brand resonates with our customers because it stands for integrity, independence, and exceptional customer service,” she says.

MSCI and FTSE Russell did not respond to requests for comment in time for publication. 

Despite complaining about rising fees at some of the incumbent index providers, asset managers continue to sign licensing agreements with them as though it’s a necessary bitter pill. According to a former chief investment officer who has 25 years of experience in institutional asset management, the choice of benchmarks is very much a peer group decision, even though the fund manager calls the shots.

“If it’s a common mandate, like Asia ex-Japan diversified, you would just use MSCI Asia ex-Japan, which is the most popular because 95% of the fund managers in the peer group are using that,” they say.

'It’s all smoke and mirrors'

Another reason why these incumbent index providers still run most of the show is the status and branding they’ve built up over the decades.

The introduction of the Dow Jones Industrial Average (DJIA) in the 19th century marked the beginning of the index and benchmark industry. While the DJIA was just a simple mathematical average, it became the impetus for early providers to then start grouping stocks and then weighting them by market capitalization—a figure that regularly changes.

This is why indexes need to be periodically reviewed, tweaked, and re-weighted to account for changes in the market.

Gareth Parker, chief indexing officer at Morningstar, was one of the four founding staff at FTSE, which is now a subsidiary of the London Stock Exchange Group (LSEG). He says an investment in the FTSE 100, when it launched in 1984, equated to a list of big UK companies that represented about 70% of the stock market at that time.

But things change over time. “What you’re now getting is a list of supranational entities that also actually stretches down into what historically we would have thought were mid-cap companies, because the index now represents the largest 90% of the market, not 70%,” he says.

An index is not a static thing—it cannot just be 100 companies selected at a given time.

It’s basically seeking rent for doing nothing

Former chief investment officer

“I think fewer than 10 of the companies that were in the FTSE 100 when I started are still in. Most have been taken over, some have gone bust. If it had not changed to reflect these shifts, it would be a useless index. So you have to have a process of periodically rebalancing that index, selecting the latest top 100,” Parker adds.

The process of re-weighting and maintaining benchmarks is one of the justifications behind the fees that providers charge for their services. Another is the price of raw data that index providers obtain. Traditionally, it was as simple as taking prices from stock exchanges and weighting the relevant stocks appropriately.

“Now, we take prices from stock exchanges, ESG data from an ESG company that’s expert in this sort of stuff, information on liquidity from a market-maker. … We have multiple places we need to go to get the data to create a good index,” Parker explains.

The UK’s FCA recognizes that building and maintaining an index can be costly. In the terms of the reference document it recently published, the FCA stated, “We appreciate benchmark administrators’ view that it is important that the pricing of benchmarks supports a sustainable benchmark business and reflects the investments providers make in innovation.”

According to S&P DJI’s Kabahar, S&P’s indexes are reviewed “at least” annually to ensure they incorporate certain market trends and changes, continue to stay timely and relevant, and meet their publicly stated objectives. “S&P DJI continues to innovate, develop and launch newer indexes that reflect our customers’ shifting needs and the global markets’ ongoing evolution,” she says.

Again, MSCI and FTSE Russell did not respond to requests for comment.

However, some disagree with the level of innovation these incumbent index providers add.

“They take your market cap, and for MSCI, they use a free float to adjust for that,” says the former chief investment officer. “But that’s about the last sort of big innovation they did 30 years ago. Other than that, it’s kind of very standard. And then, periodically, they’ll review if the stock is below or above, or is still investable at all, but otherwise, it’s basically seeking rent for doing nothing.”

One more concern the FCA is looking into is brand dominance, where customers place a high value on incumbents’ reputations or track records. According to DataCompliance’s Harris, these pressures often come from the asset owners rather than the asset managers.

“When the asset manager wants to pick an index for benchmarking, they are restricted, because the asset owners will say, ‘Hey, I want S&P, I want FTSE.’ It’s like buying Coca-Cola and Pepsi. A little kid wanting a sugar fix will say, ‘I want Coca-Cola,’ and you can give them another brand, but they’re not interested,” he says.

We will complain, and we will be annoyed, and we’ll push back and negotiate, but in the end, we’ll put up with it

Former chief investment officer

Once an index provider establishes a foothold, much like what S&P, FTSE and MSCI have done, it’s difficult for newer index providers to convince asset managers to change from the recognized brand. It’s also considered safer, according to sources WatersTechnology spoke with for this story.

S&P is known for its US large cap index, the S&P 500; MSCI is known for its global indexes; and FTSE is dominant in the UK equity market. Even the incumbents would struggle to encroach on one another’s territory by creating rival indexes.

In terms of contractual agreements, these incumbents are “very strict,” and since they’re charging by AUM, the costs add up, and there’s not much transparency around how they’re charging firms, according to DataCompliance’s Harris.

“They would say they provide everybody with the same price and that they don’t treat people differently. It’s all smoke and mirrors. And the smoke and mirrors are expensive; that’s the real problem. Fund managers have to take the indexes—they’ve got no other choice,” he says.

This combination of factors creates a high barrier to entry for new competitors. First-mover advantage and brand recognition mean that established players are like heavyweights, going head-to-head with the featherweights of the index industry.

Then there’s also the consideration of the complexity involved in changing providers, which includes changing the fund’s deed of trust. The result is that many asset managers—and by extension, asset owners—choose to stick with the norm.

The former chief investment officer says: “As much as I hate MSCI, the fact is I’d rather go with MSCI than get an exotic index provider. Changing an index of a fund or a strategy is painful and very complicated. As long as they’re not being overly outrageous. We will complain, and we will be annoyed, and we’ll push back and negotiate, but in the end, we’ll put up with it.”

The challengers

Despite the uphill battle, there are increasingly more index providers entering the market. In recent years, the popularity of passive strategies has grown alongside the increasing demand for customization.

“All of a sudden, you’re seeing self-indexing, you’re seeing thematics like ESG, faith investing, carbon investing. And all of this has brought in complexity,” says Roby Muntoni, chief commercial officer at indexing technology provider MerQube.

This trend has given newer index companies a bit of a leg up to disrupt the established index space.

MerQube, for example, was founded in 2019 as a technology-driven alternative to existing index providers. Muntoni describes MerQube as a technology provider for index providers that “powers indexes and calculates the outcome for a basket of stocks.”

Though Muntoni recognizes the power that the biggest indexing companies hold, she hints at a model that would allow the established players and newer technology providers to coexist and, perhaps, even collaborate.

“We can’t compete with S&P after 100 years that they’ve been around. But what we can do is we can provide the technology that’s going to power the strategies of tomorrow,” she says.

Certainly, costs are rising more quickly than the cost of inflation, simply because a lot of the data out there is owned in an oligopolistic manner

Rahul Sen Sharma, Indxx

One big challenge that rising indexing companies face is negotiating the provision of data. The raw cost of data is MerQube’s number one expense item, adds Muntoni.

“The more users you have, the more you can dilute that cost. And the more scale you have, the more you’re going to be able to onboard new clients and dilute those costs further and further,” she says.

Rahul Sen Sharma, managing partner at Indxx, concurs with this point. “Certainly, costs are rising more quickly than the cost of inflation, simply because a lot of the data out there is owned in an oligopolistic manner. You have some exchanges that are oligopolies, or monopolies. Same thing with data providers, and they can get away with essentially charging you what they want,” he says.

Indxx started life in 2005 with the aim of building custom indexes quickly—in a matter of days or weeks from start to finish.

Sen Sharma adds that it hasn’t been easy starting up an index business. “As an entrepreneur, I can tell you that it was twice as hard as we thought it was going to be. It took twice as long and it costs us twice as much. It was simply a matter of just showing people your value. The incumbents do have a great deal of power—that brand name recognition is something that’s historically been difficult to get over,” he says.

Speed as a USP

Quick time to market is a recurring selling point among these new index providers. One other example is CTDI, which provides customized index solutions. Its founders come from backgrounds in quantitative finance, analytics, and financial data, along with over 70 years of combined experience in trading.

CTDI uses AI in its algorithms to monitor underlying stocks as they trade every day. Paul Hsu, CEO at CTDI, tells WatersTechnology that, typically, most index companies would review index components based on fundamental analysis.

He says using AI gives CTDI better market information instead of making a call based on gut. “It give us more objective information to present to investors. If you’re going with the fundamental way, like what the likes of S&P would do, you’re taking the opinion of your analysts. That’s the problem with fundamental research and investments—you’re basically taking on the opinion of a fund manager. It’s neither right nor wrong. You can either believe in somebody’s fundamental research and instinct or the objective numbers. It’s quants vs. fundamentals.” 

CTDI was chosen over the incumbents by Brazilian multinational CMA Group to build a Brazilian soybean index to establish a coherent national benchmark price for soybeans.  

Through its business unit, Safras & Mercado, which specializes in the development of technological solutions and content for financial and commodities markets, CTDI launched the Safras CTDI Brazil Soybean Index. For Safras & Mercado, the collaboration was an easy marriage.

“We were looking to create an index that could help the buyers of Brazilian commodities to be hedged,” says Raphael Juan, director of Safras & Mercado. “We have the best information from Latin America, but were missing a specialized company that could use our knowledge in the region and our data to create this index.”

He adds that the group didn’t feel a need for the incumbent index providers to participate in taking the soybean index project forward as they don’t have the expertise in Latin America.

“These companies don’t have the data from 50 years ago like Safras does. These companies don’t have the workflow collecting market data from places that don’t even have internet,” he says.

Hsu credits his team’s experience in Chinese futures trading and their quant background.

“China is the largest importer and consumer of soybeans. For the CMA case, we were able to produce that index for them in a span of 30 days. It was really quick because we understood the data and asked the right questions to get answers from them, so the process was pretty smooth,” he says.

Crunching the data and conducting quantitative analysis on CMA’s data played to CTDI’s strengths. Hsu says that for someone else like S&P, it might take longer as they’d have many layers to go through. A five- to six-month difference could be a significant factor to many firms like CMA.

Meet in the middle

“Nobody gets fired for buying IBM” seems to be a recurring statement in the index industry, linking back to the brand dominance these IBM equivalents enjoy.

“Nobody ever got sacked for using an MSCI index to benchmark their performance to demonstrate whether they were doing well or badly as an active fund manager. And nobody ever got sacked for using an S&P or FTSE index for their ETF,” says Morningstar’s Parker.

Konrad Sippel, head of research at Solactive, a Germany-based index provider, echoes this sentiment, but adds that some firms might perceive it risky to go with a benchmark from an unknown index provider—that for whatever reason if it doesn’t work out performance-wise, they might get into trouble.

Solactive has been around for 15 years and has 300 staff. Like the other newer players, Solactive’s value proposition from the beginning has always been speed.

“It was one of the core design principles in our technology platform. Whereas I think if you’re running a huge benchmark with trillions of dollars in futures contracts set on it, safety, stability, and security are your higher priorities over flexibility,” he says.

There’s also the potential issue of a startup index provider going bust, like what happened to DWS and Nasdaq as their existing partner Yewno Inc., was forced to liquidate all its assets. They will need a new data provider for two thematic ETFs before the next rebalance in July.

The problem there is the business model that many smaller and newer index providers have, which has been to offer their services at the lowest prices possible. Historical biases and pre-existing relationships have played a role in contributing to that.

Right now, for the smaller index providers, the only way they’re competing is by charging de minimis amounts. But is that a sustainable business model?

Bruce Traan, Benchmarket.io

The status quo for index licensing has not changed over the last four decades since the first index-linked product was launched, says Bruce Traan, founder at Benchmarket.io. The startup hopes to help asset managers and product issuers secure fair and competitive licensing fees from index providers by sending anonymous requests for quotes.

“Clients will provide us with the requirements for an index. We’ll take those requirements and go to multiple different index providers on our platform and fundamentally ask, ‘Give me a market on your index licensing fees based on the requirements for this index.’ Our client will then see a spread of what is being charged for that index,” he says.

He hopes Benchmarket.io, once it’s launched later this year, will help drive competition in this space. “Right now, for the smaller index providers, the only way they’re competing is by charging de minimis amounts. But is that a sustainable business model? I don’t know,” he says.  

The demand for indexes will only continue to rise in tandem with the rise of sustainable investment strategies and digital assets, as well as the increase of participation by retail investors.  

Given this shift, a few developments could lie around the corner. It is possible, for example, that asset managers might begin to eschew the established index providers and go down the self-indexing route. Or, they could also secure lower fees by buying stakes in smaller index companies—a step that some daring entities like JP Morgan have already taken. 

If asset managers begin to push back harder on opaque fee structures, and if challenger index providers start to make significant headway that fights the status quo, it could drive incumbent index providers to change and provide more transparency into their fees.  

That might be exemplified in publishing their fees, just like how most exchanges publish their market data fees on their websites.  

DataCompliance’s Harris believes that this vision, as idealistic as it may be, could be the future. “I think that’s what must happen. Rather than just saying ‘percentage of AUM,’ they should say who’s being charged and in what way.”   

A regulatory push by the UK’s FCA, for example, could potentially be the ultimate shake-up the index industry needs. But for now, the industry will have to wait with bated breath on what the FCA plans to do after it completes its study.