Triggered by fears of rising US interest rates, stocks plummeted early in February, then recovered, before ending down. How did benchmarks designed to represent the US equity market gauge the volatile month?
The following benchmarks delivered nearly identical returns in February 2018: S&P 500 TR USD, Russell 1000 TR USD, Russell 3000 TR USD, CRSP US Total Market TR USD, MSCI USA IMI GR USD, Morningstar US Market Index TR USD.
Across the market's ups and downs, they performed within a few basis points of each other. The market capitalisation weighting approach, which ensures consistency and low turnover, drives this convergence. Consider the similar returns of the Russell 1000 Index and the Russell 3000 Index, despite a difference of nearly 2,000 stocks. Due to market cap weighting, both devoted more than 3% of their respective weight to common top holding Apple (AAPL) in February 2018.
The six benchmarks mentioned above vary in their methodologies and index parameters. Some aim to reflect only the higher end of the market, while others provide a more comprehensive view. They might be managed by committee or governed by precise construction rules. While some use a fixed number of stocks, others capture a certain percentage of the market's value, with the number of constituents varying accordingly. All are weighted according to market capitalisation – depending on how many shares in issue – and all rebalance or reconstitute periodically to reflect market changes.
While the "smart beta" phenomenon has introduced enormous complexity to indices reflecting rules based passive investment strategies – i.e. two index providers can define a factor like "quality" quite differently – benchmarks representing the market are commoditised. Investors can reduce their costs, and thereby improve their outcomes, by paying as little as possible for tracking the market.
Vanguard Takes the Lead
In 2012, Vanguard shocked the asset management industry by swapping benchmarks tracked by 22 of the firm's index funds and ETFs. For funds focused on US equities, Vanguard moved from MSCI to equivalent benchmarks built by the University of Chicago's Center for Research in Security Prices (CRSP). Outside the US, Vanguard switched to FTSE. The changes impacted funds with a total of $537 billion in investor assets, which then represented one quarter of the firm's asset base.
"There were three main reasons for this change: cost, cost, and cost," said Vanguard executive Joel Dickson in a 2012 video interview for Morningstar.com. Dickson explained that Vanguard was reacting to rising index licensing fees, which represent an ever-larger percentage of index-tracking funds' expense ratios. As a firm owned by its fund holders, Vanguard constantly looks for opportunities to cut costs and pass along savings to investors. Vanguard’s observations is that market benchmarks are essentially interchangeable.
Morningstar Open Indexes Project
Since Vanguard cited index licensing costs as the driver of its decision to swap benchmarks tracked by 22 funds, the index industry has consolidated. Fees charged for benchmarking investments and related licensing costs paid by asset managers, wealth managers, and asset owners, have risen significantly.
The paradox of increasing index licensing costs at a time of downward fund fee pressure and undifferentiated product drove Morningstar to act in 2016. Inspired by the concept of open source software, Morningstar launched a disruptive initiative called the Open Indexes Project. The goal is to make benchmarking more accessible. Morningstar is offering a subset of its global market-cap equity index series to financial services firms for general benchmarking at no cost. Morningstar is also working to make investment products tracking beta benchmarks more affordable.
Morningstar Research has demonstrated over the years that fees are a significant driver of relative investment performance. Lower-cost funds outperform. Fees also help to predict risk-adjusted returns, as the managers of higher-cost investments take on more risk just to stay even with lower-cost competitors. Because index licensing fees are ultimately passed along to investors, the lower the costs of benchmarking, the better the investor experience.
