Passive exchange-traded funds account for a staggering $9.7 trillion of the money invested in ETFs and mutual funds, yet investors have little transparency into one of its key players: index providers. Most passive ETFs track indexes from the largest index providers, with S&P Dow Jones alone claiming half of the market with the stalwart S&P 500.
Despite wielding such influence, this highly concentrated segment of the financial industry is much more opaque than the ETFs they work with. Asset managers pay licensing fees to an index provider for the rights to replicate an index, and the costs are included in an index-tracking fund’s expense ratio.
Yet there’s no required disclosure for those licensing fees, and few fund providers volunteer the information in their annual accounting statements. Index costs ultimately account for part of an ETF’s expense ratio, which has a direct impact on investors. They also affect asset managers by limiting the competitiveness of their expense ratios.
What Goes Into Fund Fees?
While most asset managers don’t disclose licensing fees, some do. Exhibit 1 lists a sample of ETFs that disclose their licensing fees from State Street (SPDRs) and First Trust. The SPDR sector ETFs track S&P indexes, while the First Trust ETFs track the Nasdaq AlphaDEX sector indexes. Asset managers typically negotiate licensing fees with index providers, so these numbers provide only an example. They will look different for different fund families and asset managers.
As a percentage of the money they oversee, the First Trust ETFs paid out almost double the licensing fees compared with the SPDR ETFs. The complexity of these indexes partially explains their higher cost. The Nasdaq AlphaDEX indexes incorporate growth and value factors to outperform their respective sector. However, the S&P indexes tracked by the SPDR ETFs use a simpler approach that only mimics the performance of each sector.
The SPDR ETFs paid out less to S&P in licensing fees as a percentage of the money parked in them, but their expense ratios were much lower. So, licensing fees account for a larger portion—almost one fourth—of each SPDR ETF’s expense ratio. That figure dropped to just 7% for the pricier ETFs from First Trust.
Index-tracking funds, and the asset managers that oversee them, aren’t giving them away for free. They’re running a business, and they need to make money. Even the cheapest ETFs are still profitable after all expenses have been paid, including licensing fees. Index licensing fees dictate how low an ETF’s fees can fall and how big (or small) the profit margins will be. Low-fee ETFs, like the SPDR ETFs, have less wiggle room, and their profit margins are much lower than ETFs charging higher expense ratios.
Competition Benefits Investors
The SPDR ETFs are unique in another regard. They’re synonymous with the S&P sector indexes that they replicate. They have tracked the same target indexes since State Street created the ETFs in the late 1990s, and it’s hard to imagine them tracking anything else. In theory, that gives S&P the upper hand in negotiating licensing fees.
That isn’t the case with other index-tracking funds. Asset managers that don’t depend on a specific index provider have options. Most of the major index providers offer similar indexes (US large-cap, US small-cap, foreign developed and emerging markets, and so on). The differences from one to another are often marginal. That creates the opportunity for asset managers to switch from one index to another while maintaining their ETFs’ intended risk/reward profile. It also promotes competition across index providers and keeps licensing fees down.
Licensing fees also differ across investment approaches. Broad-market indexes are fairly common, so few command top-dollar licensing fees. Index providers likely have more pricing power in specialized portfolios such as strategic-beta and thematic indexes. Those strategies allow index providers to flex their creativity and capabilities. They still compete on price, just not to the same extent as broad-market indexes.
Competition has driven ETF expense ratios and index licensing fees lower over the years. Anecdotally, it shows up when an index-tracking ETF or mutual fund changes the index that it tracks. Morningstar tags funds in its database that have changed their indexes, and nearly 50% dropped their fee within a year after the index switch. The median fee cut clocked in at 6 basis points, with some ETFs cutting their expense ratios by more than half. Index licensing fees are usually only part of the equation, but it shows that asset managers are keen to pass along lower licensing fees to investors as a way to keep their ETFs competitive.
Exhibit 2 shows that strategic-beta and thematic ETFs account for a majority of the ETFs that reduced their expense ratios when moving to a new target index. They typically have higher expense ratios than broad-market ETFs, so it’s easier to cut more from their expense ratios than a broad-market ETF that charges only a few basis points per year. That is borne out in the data. Strategic-beta and thematic ETFs averaged a 9-basis-point drop after switching indexes, while the latter cut by just 5 basis points.
Most of the core ETFs that cut their expense ratios after changing indexes did so as part of a much larger overhaul. For instance, Vanguard switched a number of its index-tracking mutual funds and ETFs to CRSP indexes from MSCI benchmarks in 2013. At the same time, it slashed each fund’s already low expense ratio by an additional 1-2 basis points.
Similarly, several Invesco factor ETFs have switched indexes from different providers over the years and dropped their expense ratios by as much as 10–20 basis points along the way. More recently, Invesco replaced FTSE-branded indexes constructed using Research Affiliates methodologies with indexes provided directly by Research Affiliates. The underlying strategies changed little, and Invesco cut the expense ratio on each of the affected ETFs by a few basis points. Strong relationships between index providers and asset managers may improve their ability to negotiate lower licensing fees.
There is some nuance to pay attention to. Switching indexes to reduce licensing fees and expense ratios is a win for investors. But not all index changes swap like for like. Some of those changes alter the ETF’s risk/reward trade-offs, for better or worse. For example, iShares MSCI USA ESG Select ETF SUSA and Xtrackers MSCI EAFE High Dividend Yield Equity ETF HDEF halved their fees in 2018, but they moved to slightly modified versions of their existing MSCI indexes.
While there’s little transparency around index costs, the limited data shows some encouraging signs. A large portion of funds cut their expense ratios after changing their target index, indicating they may be passing along lower licensing fees to investors. It’s a benefit, but it shouldn’t be the primary factor in making investment decisions. Licensing fees and expense ratios are already low. The underlying investment process—how an ETF selects, weights, and rebalances its holdings—should not be forgotten and is arguably more important than ever.
Morningstar, Inc., licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. A list of ETFs that track a Morningstar index is available via the Capabilities section at indexes.morningstar.com. A list of other investable products linked to a Morningstar index is available upon request. Morningstar, Inc., does not market, sell, or make any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.