Self-Indexing Trend Raises Conflict-of-Interest Concerns for ETFs

December 20th at 10:03am by John Spence

More ETF managers are opting to use in-house benchmarks for their funds to cut costs, but the trend is raising concerns about conflicts of interest in the $1.3 trillion industry.

Some ETF firms are deciding to manage their own indices rather than pay benchmark licensing fees to third-party providers.

ProShares in a recent regulatory filing requested permission from the SEC to use in-house indices for its ETFs. Van Eck’s Market Vectors and WisdomTree (NasdaqGM: WETF) are among the firms that already run ETFs based on their own benchmarks. [More ETF Firms Joining Self-Indexing Trend]

“This change has deeply divided the industry,” reports Morningstar’s Alastair Kellett.

“There are concerns about the transparency of these new ‘no-name’ indices and concerns over potential conflicts of interests,” the analyst wrote in a commentary posted Thursday. “In particular, opponents to self-indexing cite potential problems around the pricing of index constituents, the embedding of poorly disclosed costs, sub-optimal index construction methodology, and incentives to tweak the index rules to boost performance.”

Other ETF firms that have filed to self-index in the past year are Northern Trust’s  (NasdaqGM: NTRS) ETF arm FlexShares and Guggenheim Partners.

“Advocates of self-indexing see it as a way to offer investors lower fees, provided they’re willing to accept an exchange traded product that tracks a non-branded index,” Kellett notes.

Conversely, opponents say having benchmark construction and portfolio management under the same roof may create a conflict because the firm may try to create indices that are easier to track, but are not necessarily in the best interests of investors.

“Additionally, self-indexing providers may be tempted to choose constituents that are likely to be valuable in the securities lending market, which could give the firm an additional revenue boost,” Morningstar points out. “But these concerns could be effectively mitigated by a firewall between the index maintenance and the portfolio management teams. There is another concern that a self-indexing fund provider would tamper with the index rules in an attempt to boost performance.”

Adam Phillips, chief operating officer at Van Eck, in an interview earlier this year, said there is separation between the ETF manager and the index provider.

“There are safeguards in place, and we received self-indexing relief from the SEC which comes with guidelines in terms of firewalls,” the Van Eck COO said. [Van Eck Among ETF Firms Using Home-Grown Indices]

“As competition intensifies among ETP providers, it is inevitable that there will be a temptation to look more closely at index licensing fees, which are typically tied to assets under management, as a cost-cutting opportunity. In practice, the benefits of self-indexing are perhaps not as significant as they first appear, but neither are the risks as grave,” Morningstar concluded.

The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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