Who pays for the maintenance of financial indexes?

April 29, 2013 4:58 AM

In index mutual funds, many of the decisions on portfolio construction are effectively outsourced to the makers of financial indexes, thereby lowing costs for the fundholders. Doesn't this just push the costs to the publishers of these indexes? Someone has to decide which securities stay in and which ones go out. How do they get paid for this work when anyone can look up the constituents of the S&P 500 and construct a fund that just happens to share the same stocks without using the S&P name? Can Standard and Poor's somehow enforce licensing fees on institutions that do this? Do things work differently for the creators of more specialized indexes?
posted by grouse to Work & Money (10 answers total)

S&P makes available the list of constituent companies that comprise the S&P 500 index, so, in theory, an individual investor could go out and buy companies in this index. The index is a capitalization-weighted index, meaning that the company with the largest market capitalization (I believe Apple) comprises a disproportionate portion of the index's overall weight. An individual who wanted to reconstruct the index by buying individual stocks would have to take these proportions into account when constructing the index, and buy and sell stocks as their prices and hence market capitalization vary over time. This would incur transactions costs and capital gains taxes (or capital losses).

Since index companies can amortize these transaction costs over a very large base transaction costs are less of a concern.

As for licensing: I believe that S&P does license the name S&P 500 to purveyors of index fund products for marketing purposes.
posted by dfriedman at 5:10 AM on April 29, 2013

My direct experience is more with respect to structured notes, but the issuer / fund sponsor pays the creator of the index (e.g., Standard and Poors). I don't know how material the fee was, but the index was licensed. If you look at your fund's prospectus, you should see disclosure regarding the payments to the index creator.

It's the same with other indices, regardless of how exotic. We used to do notes linked to the Bovespa, Nikkei 225, Dax, VIX, etc. Everyone got paid.

You're right that one could just have a cut rate "index fund" by building out a portfolio that has the same components as the actual index, but I don't think there would be a big market for that--though, to be clear, and large-cap blend portfolio is probably going to have significant overlap with the S&P. But if I'm buying a more or less passive portfolio, I'd like to be sure that my portfolio manager has the added access that comes with being an official licensee, etc., rather than being reactive in the market after something is announced in the WSJ, etc.
posted by Admiral Haddock at 5:10 AM on April 29, 2013 [1 favorite]

Best answer: Yes, see here for licensing.
posted by dfriedman at 5:11 AM on April 29, 2013

Yes, if you want to market an index to the public you pay the index provider.
posted by shothotbot at 5:15 AM on April 29, 2013

Structured notes are an interesting example of this. Lawyers I know who work on structured notes have told me that their clients, who are the ones buying the structured notes, often require the issuer to disclose that the issuer has paid the relevant fees to the index creator/publisher. I suppose the concern is that the people buying the structured notes believe that they could be sued if they by a structured note based on an unlicensed index or something....
posted by dfriedman at 5:29 AM on April 29, 2013

Best answer: Here is an example of a mutual fund company switching from one company's indexes to another to save license fees: Vanguard to change target benchmarks for 22 index funds.
posted by smackfu at 5:41 AM on April 29, 2013 [2 favorites]

You should read MSCI's 10-k. They are a big index provider as well.
posted by JPD at 5:56 AM on April 29, 2013

In index mutual funds, many of the decisions on portfolio construction are effectively outsourced to the makers of financial indexes, thereby lowing costs for the fundholders.

This is only partially true. The index serves as a model, but actual portfolio construction is left to the sponsor of the ETF (BlackRock in the case of iShares, Vanguard, State Street, etc). Matching the performance of a benchmark day-to-day is a non-trivial operation.

In theory, you could sell a generic passively managed fund invested in large US companies without paying S&P. But you wouldn't be able to market it as a "S&P 500" index. And you also have to pay S&P (or Russell or MSCI) if you want* to include benchmark performance data in your materials for purposes of comparing the fund's results against the benchmark. Same goes for actively managed mutual funds.

* "want" isn't really the right word. The SEC requires funds to compare performance against a relevant benchmark. It doesn't have to be a brand-name index, but good luck marketing a fund that's benchmarked against "grouse's list of awesome companies".
posted by mullacc at 6:44 AM on April 29, 2013

Vanguard, the king of low cost index investing, recently switched indexes in order to "save millions of dollars in licensing expenses for the funds".
posted by notme at 6:54 AM on April 29, 2013 [1 favorite]

adding to mullacc said - most ETF's don't actually own the underlying securities - they basically depend on people delivering shares in the underlying or demanding shares in the underlying from them if the funds nav trades rich or poor relative to the index.

Traditional Passive funds are also often not run by just buying all of the constituents of the index.
posted by JPD at 7:32 AM on April 29, 2013