How ETFs choose their indexes

Have you seen an ETF launch recently and wondered whether the index it tracks existed previously? There’s a good chance it did not.

The global ETF business is booming, and with it, the number of indexes has surged. Bloomberg reports that the number of indexes in the U.S. has risen to about 5,000, surpassing the total number of U.S. stocks, which have declined since 1995. Market strategists say it’s just the beginning for the rise of index-tracking ETFs.

Choosing what to track

For ETF providers, deciding on an index is largely an exercise in finding a product that’s helpful to advisors and investors. Fund managers are looking not just for unique offerings, but for growth areas, product demand and portfolio needs.

Pat Chiefalo tries to cross the country once or twice per year to meet with advisors. Chiefalo, head of iShares Canadian products at BlackRock Asset Management, the country’s largest ETF provider by assets under management, has seen the demand rising first hand, estimating 10% to 25% annual growth in ETF assets in Canada over the past eight years.

Last year, based on what investors and advisors asked for, his firm launched Canadian-dollar hedged versions of its global minimum volatility products, which track global MSCI indexes. Chiefalo says his firm can start work on indexes and launch new ETFs (with their new, respective indexes) within a few months, though a unique idea could take longer.

Creating a universe

The ETF manager will typically work with the index provider to tweak the index as necessary. While the fund manager has input on conditions and exclusions, the index provider creates the universe.

“We’re kind of the Intel inside of a computer, if you will. We are actually defining the universe,” says Ken O’Keeffe, global head of ETFs at FTSE Russell in New York. “They will have input on those types of decisions. But the starting universe for, let’s say, FTSE Canada All Cap—if they want Canada exposure, we’re going to start there. Then, in dialog with them, we might change [it].”

While fund managers meet with advisors for ideas, index providers are also surveying the landscape for new products and building indexes according to their expectations of demand. FTSE, for instance, says it is constantly looking at additional indexes, like equal weight, fundamental weight, factor indexes, dividend weight, and minimum variance indexes, and building them in the event that advisors ask.

Fees

The major indexes (e.g., S&P, FTSE, MSCI, or Nasdaq) tend to charge ETF providers by basis points on AUM. Some smaller, newer index providers may charge a flat fee, perhaps $20,000 per year.

The fees charged depend on the index’s conditions, complexity and the factors applied. The fewer the inputs, the cheaper the service. Large, commercially recognizable index providers can charge more, while big ETF providers have negotiating leverage for a better price, says Kevin Gopaul, head of BMO Global Asset Management for Canada and global head of ETFs.

ETF providers include the index pricing as part of their management expense ratios, or total fees. There’s an informal industry rule that says 10% to 20% of the total MER goes to the index provider, says Gopaul, who oversees Canada’s second-biggest ETF provider by AUM. “This is what I’m seeing globally,” he says.

But, as the space grows, so does the competitive pressure to drive down ETF expense ratios — and fund managers are increasingly looking at index providers’ fees. The Financial Times reported in May that some large managers, like State Street, BlackRock and Vanguard, were considering co-operating to provide a more cost-efficient form of self-indexing.

Competitive space

At the same time, newer index players are emerging with competitive offers, Gopaul says, pointing to Solactive, an index provider based in Frankfurt.

“Some of the newer ones like Solactive come in with a very different value proposition. They come in at a very low cost and it’s, ‘Don’t worry about my brand name; I’ll have the strongest German engineering behind this,’” Gopaul says.

BMO launched a preferred share ETF (TSX: ZPR) in 2012, working with Solactive on a unique product and index, Gopaul says. While the bank works with the major providers, including MSCI and FTSE, it couldn’t find another index provider offering the unique combination of stability and yield, Gopaul says.

The rise of indexes and factor ETFs mean investors should be prepared to sift through a lot more options as ETF product launches accelerate.

“You can slice and dice Canada into, literally, hundreds of industries and sub-industries. Of course, you can do that for every country in the world, and we can do that for any amalgamation of countries around the world,” says O’Keeffe, of FTSE.

Slice and dice those indexes again as you input other factors like currency hedges in U.S. dollars, euros or yen, and “you just get this unbelievable amount of indexes,” he says.