Price behind world's biggest benchmark switch: Vanguard

US-based indexing specialist Vanguard Investments has confirmed that its decision to drop MSCI for  FTSE as benchmark provider for six international equity index funds was chiefly price-driven.

But Robin Bowerman, Vanguard’s head of market development and corporate affairs based in Australia, also notes it fundamentally agrees with FTSE that South Korea is a developed market and should not be in an EM index. MSCI currently includes Korea in its emerging markets index.

This week it was announced that Vanguard had picked FTSE as benchmark provider for six of its US-domiciled equity index funds with aggregate assets of $170 billion – the largest ever switch of its kind, including the $67 billion Vanguard Emerging Markets Stock Index Fund and its ETF.

At the same time Vanguard unveiled plans to transition 16 US stock and balanced index funds away from MSCI to new benchmarks developed by the University of Chicago’s Center for Research in Security Prices (CRSP). Again, this was price-driven.

Bowerman notes the cost of index licensing is taking up a growing proportion of the expenses that investors pay. “If you go back five years, expense ratios have come down but index licensing fees haven’t,” he says. “So cost is a big factor. From an investor’s perspective, over the long-term these changes will enable us to deliver value and lower the expenses over time.”

One AsianInvestor source suggests that the decision on which index provider to use should be based on return of comparative indices over multiple time periods to see which has done better, including ancillary information on volatility.

FTSE says its Emerging Index returned 166% gross between the end of 1993 and September 30, 2009, and 17.9% from September 30, 2009, to September 30 this year. In contrast, over the same periods, MSCI says its EM index returned 146.9% and 18.9%, respectively.

Interestingly, by weightings, FTSE's emerging index sees China top at 16.7%, followed by Brazil at 16%, Taiwan at 13%, South Africa at 10.5% and India at 9.6%; MSCI's EM index also has China highest at 17%, followed by Korea at 15.6%, Brazil at 12%, Taiwan at 11% and India at 7%.

But Bowerman confirms that Vanguard’s decision to switch had nothing to do with performance, after a comprehensive review of both sets of indices (FTSE and MSCI).

“The index construction is around capturing the market turn, there is nothing we are looking at which is performance based," he says. "It is about whether these indices do a job for investors over the long term and deliver best-practice index construction, while giving us some cost certainty.”

He declines to reveal how long-term the contracts are, as does a spokesman for FTSE, who describes it as confidential. The indication is that the contract negotiation process with MSCI broke down over price.

Bowerman notes there is greater price competition in the ETF arena generally in the US. “As you get greater competition you are going to be looking at your costs as a whole, whether that is index licensing fees or any other fees. We are not scared of that but we will always look to do deals that make sense for us and we will continue to work in that way.”

It is estimated the transition of the 22 funds will take several months; by the end it will mean Vanguard no longer references any MSCI benchmarks on its US-domiciled range, either domestic or international.

Vanguard is primarily known for its low-cost index funds and ETFs, although most of its assets in the US are now accounted for by third-party active mutual funds, largely sourced via a multi-manager approach.

But it is targeting an institutional build-out in Asia. Its biggest operation outside of the US is in Australia, where it has some 275 staff and around A$62 billion under management. There it deals exclusively in index-funds and ETFs for institutional investors.

Bowerman confirms that a number of Australia-domiciled Vanguard funds continue to track MSCI indices. Asked if there were plans to change on that front, he responds: “We have no plans to at this point, although we are constantly reviewing ways of reducing costs.”

For its part, FTSE prefers to argue there was a number of factors behind Vanguard’s decision to switch, rather than cost alone, noting that the US-based firm takes very considered decisions.

But Donald Keith, deputy chief executive of FTSE based in London, does admit price comes into it. “We have always had the ability to innovate and work with clients in a way that works with them and price is important in that,” he says.

“While we will always seek to be competitive we do not see this as a price-led game. We are a commercial entity and any deal has to be sustainable because otherwise we would suffer the consequences.

“But there is no question the index-provider world is getting more competitive and clients are looking for very competitive deals. Look at financial markets, everyone has been suffering and therefore they are inevitably going to look to do the best and most cost-effective deals they can, so we have to be able to respond to that.”

Asked if FTSE has lowered its costs, he says no. “We are still investing as we go round the world. We have made a lot of investments in Asia in all parts of the business – commercial, research and operational staff – and we will continue to invest."

He notes that while four years ago FTSE had just 10-15 investment professionals in Asia, it now has 50-60, including 37 in Hong Kong.

Keith adds the world of indexing is becoming more complex as institutional investors seek an array of different benchmark types. “It becomes a matter of scale and you have to make investments. The world’s major asset owners, both sell-side and buy-side, are looking for global solutions and they want you to be able to deliver that wherever.”

Asked if she felt cost was the decisive factor in MSCI losing out to FTSE in benchmarking the 22 Vanguard funds, MSCI’s head of Asia ex-Japan, Deborah Yang, says it is focused on expanding its client partnerships globally.

She stresses that MSCI places emphasis on quality and consistency, indicating that people need to be prepared to pay for that. She adds that it is still the leading provider for global indices.

“Clearly the US retail market for ETFs is highly competitive and news of wins and losses, although disappointing, do happen,” Yang says.

But she says the firm has a strong position in Asia, where the market is evolving. “We will continue to focus on innovation, adding value and efficiency for clients. We are excited to have licensed MSCI China A as a basis of an exchange-traded fund as part of the renminbi-qualified foreign institutional investor programme.”