Private Label Groceries To Private Label Indices
Just when we thought index investing couldn’t get any cheaper, State Street Global Advisors recently announced that it was cutting fees on fifteen exchange traded fund (ETF) products to as low as 3 basis points. This means $1 billion of funds under management generates a meagre $300,000 of management fees – hardly enough to cover the cost of licencing an index itself, let alone paying for any staff. So how does State Street, and other ETF providers, get around this little issue? Enter the proprietary index.
The concept of private label, and the shift away from brand names towards these no-frills labels, is nothing new. Retailers have been growing their private label mix for years in pursuit of price leadership. The same is now happening in the passive ETF space. Developing an index is cheap – anyone can pick a list of X stocks using some set of criteria. Instead of paying exorbitant fees (any fee is exorbitant when you only have 3 basis points to play with) to licence “brand name” indices from the likes of S&P Dow Jones and FTSE Russell, ETF providers are opting to create their own “private label” indices to track against. For its three cheapest ETFs, State Street developed its own proprietary mid-cap, large-cap and broad-market US equity indices.
However, there is an important difference between private label groceries and private label indices. When you buy a bottle of Home Brand cola instead of Coke, you have an idea of what you’re getting. When you buy an ETF that tracks a proprietary large-cap index instead of, say, the S&P 500, you have no idea what you’re getting. For a saving of a thousand bottles of Home Brand cola, you can throw $1 million of your wealth into a product that may or may not perform as well as the S&P 500. And therein lies the problem – how does an investor measure the performance of an ETF that tracks a proprietary index? Passive investors are relative-return investors who want to do as well as the market. But what is the market here? If the proprietary ETF closely tracks the proprietary index but lags the S&P 500 by 1%, should the investor be happy to have paid only 3 basis points for an ETF that tracked its “market” index, or sad that a 1% tracking error against the S&P 500 cost her c.80 basis points of returns?
The other thing to consider is how these proprietary indices are designed. Rules-based index design introduces elements of active management with no focus on performance (where “passive” is defined as the S&P 500 or another well-recognised index). Questions on the number of constituents, weightings, and other selection criteria must be answered, but an ETF that charges only 3 basis points typically can’t afford expensive research or analysts. The best an investor can hope for is a list of stocks that are sufficiently different from the “brand name” indices to not infringe on IP, yet sufficiently similar that the tracking error doesn’t outweigh the basis points saved on fees.
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