Academics Study Competition in Index Providers, ETF Sponsors Sector

Researchers at the Annual Conference on Financial Market Regulation presented papers on various topics affecting the industry and financial market regulation. One of the papers, Index Providers: Whales Behind the Scenes of ETFs, examined the competitive landscape between ETF sponsors and index providers and how their interactions influence ETF investors. The researchers recognized that the index provider market is highly concentrated and dominated by a few large players. They note for example, that about 53% of all ETF assets in their sample track the indexes built by S&P Dow Jones and that the five largest index providers in the U.S. equity ETF market capture in aggregate about 95% of the entire ETF market. The researchers posit that ETF investors care about the identities of index providers, even though the identities of index providers explain little of the variation in ETF returns. “…[W]e find that the index-provider fixed effects have literally zero explanatory power for ETF returns. This finding suggests that the brand value of index providers likely arises from more trustworthy brands or better recognition among investors.” The academics document that about one-third of ETF management fees are paid as index licensing fees to index providers. Using a structural model that incorporates the two-tiered competition among index providers for ETFs and among ETFs for investors, they showed that index providers wield very strong market power. “We estimate that about 60% of index licensing fees are markups charged by index providers and show that improving competition among index providers can reduce ETF management fees by up to 30%.”  The researchers assert that their analyses suggest that the entry of new index providers has little effect on incumbent index providers and on ETF investors in an uncompetitive index providing market. “In contrast, policies that directly promote competition among index providers would be effective in reducing index licensing fees and ETF management fees. One such policy may be the mandatory disclosure of licensing fees.”