Can you take me higher? How the Big Three benefit from the dominance of index providers

Index providers create and license indices as benchmarks for passive managers to track. Index providers like S&P Dow Jones, CRSP, FTSE Russell, and MSCI have become huge, profitable and influential businesses, with more than $6.5 billion in revenue in 2023 and profit margins in the range of  60-70%.

The largest such index—the S&P 500, a product of S&P Dow Jones (S&P), a division of S&P Global Inc.—is tracked by over $4 trillion, generating licensing fees for S&P of hundreds of millions of dollars per year with a present value of many billions of dollars. Passive fund managers who wish to sell a fund with the S&P 500 label must pay these licensing fees to S&P.

The entrenched and highly profitable business of licensing indexes for passive management is puzzling. The largest equity indices like the S&P 500 and FTSE Russell 1000 are merely market-capitalization-weighted portfolios without meaningful creative input. The largest passive fund managers could offer and promote ‘private label’ market-capitalization-weighted funds at lower cost—certainly zero and possibly even with a basis point or two rebate—at a huge savings for end-investors.

Why, then, do passive fund managers pay these fees, which are then passed on to their investors? The puzzle is especially intriguing because without the costs associated with using the index provider’s brand name, passive funds would dominate active funds by an even wider margin. By offering passive funds that perform even better against active funds, the largest passive fund managers could accelerate the move away from more expensive active equity management that has helped their passive fund management business grow enormously. Fund managers will construct private label passive funds for some of their largest clients. Those privileged clients then pay zero fees to the asset managers, who in turn make their money from securities lending from the zero-fee portfolio. But where are the private label passive funds for the masses?

In a paper forthcoming in the William & Mary Business Law Review, I explore a plausible explanation for the strange dominance of index providers. I propose that it is the even-better performance against active funds that such private label passive funds would demonstrate that is the key to understanding the enormous profits that index providers earn for so little value provided.

Large passive fund managers also provide active funds alongside their passive funds. They have long struggled to demonstrate that their much more expensive active offerings are worth the fees they charge. Therefore, despite their protestations to the contrary, the Big Three—Vanguard, BlackRock, and State Street—benefit from those fees because they help keep their passive funds less competitive with their active funds than they would be otherwise.

This incentive to reduce the performance differential with active offerings has become even stronger in recent years. There simply is far less money in managing passive funds than in managing active funds and the Big Three do both, especially the largest asset manager, BlackRock.

Consider BlackRock Inc.’s S&P 500 ETF, the iShares Core S&P 500 ETF (ticker: IVV). In June 2020, BlackRock cut its fee from 0.04% to 0.03% to match the lowered fee on Vanguard’s S&P 500 ETF (VOO).  By contrast, BlackRock’s Future Climate and Sustainable Economy ETF (ticker: BECO), an actively-managed ESG fund, has a management fee that is 23 times higher at 0.70%. 

If BlackRock takes an action that increases assets under management in its S&P 500 ETF by $1,000 but decreases assets in its actively-managed ESG fund by the same amount, it generates $0.30 of management fees (=$1,000 x 0.0003), all or most of which is paid to S&P for its license, at a cost of losing $7.00 in management fees (=$1,000 x 0.70%).

Put differently, BlackRock is slightly better off keeping just $43.00 in the active fund with a 70 basis points (bps) fee than obtaining an additional $1,000 in index flows with a 3-bps fee, since $43 x 0.007 equals $0.301. The gains from further passive flows are tiny and the potential losses from active investors who might be enticed by even less expensive and even better performing passive funds are large.

The relationship among index providers and passive fund managers is akin to a hub-and-spoke relationship well known in antitrust law. In this view, the index provider is the hub and the passive fund managers are the spokes. Index providers allow the largest passive fund managers—the Big Three of BlackRock, State Street, and Vanguard, among others—to commit to and maintain higher pricing for trillions of dollars of passive offerings. Doing so leads to higher prices for investors who pay the fees the index providers collect, reduces innovation in the market for passive fund management, and results in fewer and more expensive choices for investors.

Absent evidence of an illegal agreement to pursue this behavior, however, we are left with a strange equilibrium in which passive fund managers complain about the high price of licensing the index providers’ weights and trademarks needed to label a fund an ‘S&P 500’ index fund or a ‘FTSE Russell 1000’ index fund, but where passive fund managers are better off keeping the price of their passive offerings slightly higher and thus slightly less competitive than those products would be absent the fees and costs generated through branding.

This is a very valuable equilibrium for the Big Three and the index providers despite its effects on their investors who pay a premium to keep active offerings from looking even worse.

James B. Heaton is Managing Member at One Hat Research LLC.

The paper is available here.