Passive exchange sales funds account for an astounding $9.7 trillion, an $9.7 trillion invested in ETFs and mutual funds, but investors have little transparency into index providers, one of the key players. Most passive ETFs track indexes from the largest index providers and claim only in S&P Dow Jones Half of the market With the Stalwart S&P 500.
With such influence wielding, this highly concentrated segment of the financial industry is much more opaque than the ETFs they work for. The asset manager pays the index provider a license fee for the right to reproduce the index, and the costs are included in the index tracking fund’s expense ratio.
However, there is no disclosure required for these licensing costs, and few fund providers volunteer their information in their annual accounting statements. Index costs ultimately represent a portion of the ETF’s expense ratio. This has a direct impact on investors. It also affects asset managers by limiting the competitiveness of the expense ratio.
What is the fund fee?
Most asset managers do not disclose license fees, but some asset fees do not. Figure 1 lists examples of ETFs that disclose license fees from State Street (SPDRS) and First Trust. SPDR sector ETFS tracks the S&P index, while the first TrustETFS tracks the Nasdaq Alphadex sector index. Asset managers usually negotiate license fees with index providers, these numbers provide examples only. They look different to different fund families and asset managers.
As a percentage of the money they oversee, the first trust ETF paid almost twice the license fee compared to the SPDR ETF. The complexity of these indexes partially explains the higher costs. The NASDAQ Alphadex index incorporates growth and value factors, which outperforms each sector. However, S&P indexes tracked by SPDR ETF use a simpler approach that mimics the performance of each sector only.
The SPDR ETF is no longer paid to S&P with license fees as a percentage of the amount parked, but the cost ratio is much lower. Therefore, license fees account for the majority (almost a quarter) of the expense ratio for each SPDR ETF. That figure fell to just 7% for more expensive ETFs from First Trust.
Index tracking funds, and the asset managers that oversee them, do not offer them for free. They run a business and need to make money. Even the cheapest ETFs are profitable after all costs, including licensing fees. Index license fees determine how low the ETF fees are and how much profit margins can be (or small). Like SPDR ETFs, low-cost ETFs have less sloppy room and charge a much lower cost ratio than ETFs.
Competition benefits investors
SPDR ETFs are unique in another way. They are synonymous with the S&P sector index they replicate. Since State Street created ETFs in the late 1990s, it has been tracking the same target index, and it’s hard to imagine tracking anything else. In theory, it will have the advantage in negotiating the license fee with S&P.
This is not the case with other index tracking funds. There are options for asset managers that are independent of a particular index provider. Most major index providers offer similar indexes (e.g. large caps in the US, small caps in the US, foreign developed and emerging markets). Some differences are often slight. This gives the Asset Manager the opportunity to switch from one index to another while maintaining the ETF’s intended risk/reward profile. It also promotes competition across index providers and reduces licensing fees.
License fees also vary depending on your investment approach. The broad market index is fairly common, so there is very little license fee for commands at the highest dollar. Index providers may have more pricing power in specialized portfolios such as strategic bettas and theme indexes. These strategies allow index providers to bend creativity and capabilities. They are still competing for prices, but that is not simply on par with the broad market index.
Competition has led to a decline in ETF cost ratios and index licensing fees over the years. Anecdotally, it appears when an index tracking ETF or mutual fund changes the index tracked. Morningstar tagged funds on databases that changed indexes, with nearly 50% lowering the rate within a year of index switches. The median was reduced by 6 basis points, with some ETFs reducing their cost ratios by more than half. Index license fees are usually only part of the equation, but they show that asset managers are keen to hand over lower license fees to investors as a way to keep their ETFs competitive.
Figure 2 shows that strategic beta and theme ETFS account for the majority of ETFs that reduce cost ratios as they move to new target indexes. Usually, they have a higher expense ratio than a wide market ETF, so it’s easier to cut more from their expense ratio than a large market ETF that only charges a few points a year. It is based on data. Strategic Beta and Theme ETFs made an average of 9 basepoint drops after switching indexes, while the latter cut at just 5 basis points.
Most of the core ETFs that reduced their expense ratio after changing the index, did so as part of a much larger overhaul. For example, Vanguard switched many index tracking mutual funds and ETFs from the MSCI benchmark in 2013 to CRSP indexes. At the same time, we reduced the already low expense ratio for each fund by an additional 1-2 base points.
Similarly, several Invesco Factor ETFs have switched indexes from different providers over the years, removing 10-20 basis points along the way. More recently, Invesco has replaced FTSE branded indexes built using research-related methodologies using indexes provided directly by research-related affiliated people. The underlying strategy remained little different. Investco has reduced the expense ratio for each affected ETF several points. A strong relationship between index providers and asset managers may improve their ability to negotiate lower licensing fees.
There is a nuance to pay attention to. Switching indexes to reduce license fees and cost ratios is a win for investors. However, not all index changes are exchanged in the same way. Some of these changes change the risk/reward trade-offs in ETFs, for better or worse. For example, the iShares MSCI USA ESG SELECT ETF SUSA and XTRACKERS MSCI EAFE HIGH DIVIDEND AIGHT EICITY ETF HDEF halved the fee in 2018, but moved to a slightly modified version of the existing MSCI index.
There is little transparency regarding index costs, but the limited data shows some promising signs. After changing the target index, the majority of the funds are shown to reduce the cost ratio and may pass low licensing fees to investors. It’s an advantage, but not a major factor in making an investment decision. The licensing fee and cost ratio is already low. The underlying investment process – How ETFs choose, weight and rebalance their holdings is unforgettable and undoubtedly more important than ever.
MorningStar, Inc. licenses a licensed index to financial institutions as a tracking index for investable products such as Exchange-Traded Funds sponsored by financial institutions. License fees for such use are paid primarily by sponsoring financial institutions based on the total assets of the investable products. A list of ETFs that track MorningStar indexes are available in the Features section of indexes.morningstar.com. A list of other investable products linked to the Morningstar Index is available upon request. Morningstar, Inc. does not sell, sell, or make any representations regarding the prudentity of investing in investable products that track Morningstar Index.
