New index providers will enable ESG investors to invest in line with their principles but, says John Willis, Director of Research, Planet Tracker, the new generation of indices must maintain high standards of objectivity and transparency.
With the growth of passive investing, the role of benchmarks and indices has also grown. As of March 2020, passive funds accounted for 41% of combined US mutual fund and ETF AUM: up from 3% in 1995 and 14% in 2005.
The index ‘majors’ – MSCI, FTSE Russell, S&P Dow Jones and Bloomberg – are some of the most powerful players in the financial markets. Yet they are being challenged by innovative competitors responding to the demand for greater consumer choice, including for sustainability-based investment products. This demand could catalyse the drive towards self-indexing, enabling sustainable investors to invest in line with their personal principles rather than the standard templates on offer.
The current business model of the index majors is extremely profitable. For example, in 2020, MSCI’s index business segment reported adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) of US$766 million – a 14% rise on the previous year. The EBITDA margin for this division is an impressive 75%, compared to 57% for all divisions. It makes sense, given this, that the index majors wish to attract investors to their larger and more widely used indices, rather than an array of more specific ones. When Legal & General Investment Management (LGIM) – a UK asset manager – was searching for customised ESG indices, it commented that a number of index providers, aside from JPMorgan, “couldn’t or wouldn’t help create LGIM’s preferred benchmarks because it undermined their existing business”.
The established providers are showing some signs of change, but these changes tend to be small and slow, especially compared to newer rivals. For example, MSCI has announced that, for the current financial year, it will reorganise its divisional reporting by creating a new ‘ESG & Analytics’ segment, which formerly resided in the ‘Others’ category.
Profitability attracts competition, of course. So, while the index majors may resist change, new entrants will be only too willing to meet demand. Demand for both fixed income and ESG indices has increased considerably. In 2019, ESG indices rose by 14% across both equities and fixed income year-on-year. In light of this demand, offering more customised products appears a sensible strategy for second-tier index providers – such as CRSP, Morningstar, Qontigo and Solactive – to gain some of the indexing market share.
Self-indexing – whereby an asset manager maintains ownership and control of the index and the related intellectual property – also poses a threat to the index majors. MSCI makes no secret of the competition it could face from its own clients. In its 2020 10-K filing, it states that “growing competition also exists from industry participants, including asset managers and investment banks, that create their own indexes”. Furthermore, MSCI reveals the importance of business from the largest financial institutions, with BlackRock accounting for 11% of its total revenues.
The challenges for new providers and self-indexing
Becoming an index provider or self-indexing comes with certain challenges. Indices form the benchmarks against which the performance of both passive and active investments is measured, and they aim to be objective by providing independent, unbiased data. The primary qualities of a good benchmark are:
- Representation of investor risk and return goals
- Priced daily (as a minimum)
- Specified in advance
- Low turnover
These are vital qualities for ESG or sustainable investments. The index providers must minimise any subjective judgements and ensure that construction policies remain rules-based. For example, index methodology may need to define such issues as human rights abuses and the consumption of single use plastics. For climate change indices, many index providers have used carbon metrics as a basis of measurement. But what will they use for nature-based measures such as biodiversity?
There is also the issue of regulation. Some regulators have already expressed concerns about the potential proliferation of customisable indices. In 2018, the EU Benchmark Regulation (BMR) was introduced amid fears about the accuracy and integrity of indices used as benchmarks in EU markets, following the London Interbank Offered Rate (LIBOR) scandal. BMR imposes requirements upon organisations that provide, reference or contribute data to financial benchmarks. Regulators will also need to ensure that the largest asset managers, which may sit on the advisory boards of index providers or provide them with advice, are unable to influence the formation of indices.
Furthermore, some highly customised indices may be used for a single fund. This raises the question of what happens when the index and the fund are run by the same manager, as in the case of self-indexing. In this situation, the investment manager measures the performance of their own fund relative to their own benchmark. And if the fund underperforms the benchmark, the manager should consider ceasing active management and, in turn, reduce the management fees they are charging, for what has now become a passive investment. These issues could render indices far from objective and transparent.
The opportunity for investors
Despite the array of challenges, increasing customisation presents a long-awaited opportunity for investors of all types to invest in line with their principles. Financial institutions and ultra-high net worth individuals are already benefiting from customisation, while retail investors are limited in choice. One of Planet Tracker’s recent reports – ‘Online Retail Investors: Can’t see the wood for the trees!’ – highlights the limited search functionality of investment websites and the difficulties this creates for retail investors trying to identify sustainable or ESG investment products. Customisation would also tackle the issue of opaqueness. See our report – ‘Exchange Traded Deforestation’ – for the opaqueness of deforestation risks in ETFs.
Some financial institutions are already building their own indexing capacity. For example, Morgan Stanley announced its acquisition of Eaton Vance last October. This acquisition included, among other assets, Calvert and Parametric. Calvert is a pioneer in responsible investing, while Parametric is a leader in custom separately managed accounts. The door is therefore open for Morgan Stanley to offer customised and self-indexed ESG funds to its customers.
Similarly, BlackRock purchased Aperio – a leader in direct indexing – last November for US$1.05 billion, at an estimated 50 times earnings. This allows BlackRock to customise existing equity indices and create bespoke portfolios to meet client needs.
Some stock exchanges are also active in this area, but they may take a different path. Deutsche Börse owns Qontigo, which comprises the well-known DAX and STOXX indices, as well as Axioma, the investment management solutions company. It offers ESG index solutions, including product-based screenings of the flagship benchmarks and more thematic versions founded on its leading indices. More importantly, Deutsche Börse is testing further customisation with STOXX iStudio, which provides the customer with the tools to build their own index. This suggests the company is willing to become a disruptor.
Ultimately, disruption looks inevitable and the index majors will need to respond, but for financial reasons they are likely to hold out for as long as possible, relying on their long-standing reputations. In the shorter term, smaller index providers and self-indexing will enable ESG investors to align their money with their principles. It is crucial that new providers and asset managers that choose to self-index maintain high standards, to ensure that the new indices are objective, transparent and truly ESG-aligned.