The role of index providers in capital markets has evolved dramatically over the years. The first indices were used to help sell financial newspapers, but by the 1970s, they became the basis of index funds. These were the first steps towards the commercialization of data and intellectual property which birthed todays crowded index industry.
Increased understanding of the business breadth and workings of index providers, coupled with a continued shift of assets from active to passive, has spurred major growth in indexed based product offerings. Index providers adapted their business models to reflect this tremendous growth; and with the ability to increase licensing of index intellectual property to product issuers, profitability and revenues grew significantly as did the industry’s influence in the capital markets.
With the growth in demand, index providers became more innovative in their design. No longer is an index just measuring a broad market or market segment. Today, an index is more likely to be the basis of an investment theme, slicing and dicing the market in almost endless types of market exposures and outcomes. In fact, almost any quantitative strategy can be offered as a rules-based index. With the growth in indexed-based investing, there has been a tremendous growth in the number of index providers. Index providers are now competing not just on calculating and publishing an index but on the ability to provide a new and differentiated index product.
While it is easier than ever to develop a new index, this accessibility does not translate automatically into being a successful index provider. The cost of licensing an index has dropped significantly, and the costs of running an index business have increased. Pricing is more competitive, and even the big index providers are now more price sensitive. The focus of most index providers today is meeting the seemingly insatiable appetite for new and innovative exposures. Whether it is thematics, factors, ESG or other new concepts, there are innumerable choices of indices and providers available. Providing indices still offers attractive revenue growth and improving margins, but costs for data, technology and qualified staff are also rising, providing significant advantage to firms with the ability to scale their operations.
The increase in the number of new index providers, along with the perceived dominance of the large established players raises some interesting questions. What is the value proposition of an index provider and how much should one be willing to pay for their intellectual property? There are also the inevitable, and justifiable, concerns about increased regulation, which we touch on in part 2 of this series.
The new battleground is in terms of innovation in index design and speed to market to capture a first mover advantage. Index providers need to adapt and become even more customer centric in addition to providing an index methodology that is sound, transparent and managed without conflicts of interest. Furthermore, index providers should provide research and analytics to help investors understand what they are investing in. This transparency is key to product success. Understanding what the end-investor or financial advisor wants is critical. Index providers should increase their efforts to help their direct customers, the product issuers, to be successful in gathering assets.
Choosing the right index provider partner can be critical to a successful product. There are many elements that set apart a good index provider from the rest. One of the most important considerations is the governance structure used to oversee its indices. Following best practices or IOSCO Principals are now table stakes, and index providers need to ensure their process is free of conflicts of interest. While walling off an index provider within a larger organization is possible, working with an independent provider that is unaffiliated with the entity issuing the investment products minimizes any risk of a conflicts and sends a message of true independence to the market.
While product issuers may feel that they no longer need a brand-name and can design their own indices or work with a lower-cost provider, the question one must ask is whether this is worth it? The unit cost of an index license has come down dramatically, and this trend can be expected to continue due to the scale nature of the industry. Rather than focusing on the lowest cost, product issuers should look to work with index providers that can assist their efforts by providing support such as marketing and business development. Index providers, and their well-known and respected brands, can be a big differentiator in a highly saturated market.
The future of index providers will continue to evolve. They will develop more unique and complex indices because that is what the market demands. These indices will be offered in many different types of product wrappers in an effort to build scale. There will also be the likelihood of increased regulation which will have the knock-on effect of making the big providers even bigger and putting many of the smaller providers out of business. The big providers will have the scale across all asset classes and can support customers in all geographies.
Alex Matturri is the retired CEO of S&P Dow Jones Indices and currently an advisor to The Index Standard and a member of the Board of Directors of CBOE Global Markets.