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How to find the right ETF index service provider

How to find the right ETF index service provider
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Picking the right index service provider can make or break your new ETF product. 

With nearly 4,000 ETFs competing for shelf space in the United States alone, in today's competitive ETF ecosystem, issuers need an ETF services partner as invested in the asset growth of the product as they are that can help them design and maintain their index as an index provider.

ETF issuers have different needs, but some approaches lead to better outcomes than others. You need to know what works to avoid the common pitfalls that can derail new ETF launches. 

Here’s everything you need to know to find the right ETF index service provider, from what type of evaluation criteria to use to how to spot red flags before you commit.

What ETF index service providers do

Traditionally, ETF index service providers calculate and maintain market indices for exchange-traded products. 

These indices can be licensed and are frequently used for two purposes - benchmarking to measure investment performance, or for a rules-based investable product to track. A good index partner will accurately track corporate actions, including mergers, stock splits, and dividend payouts in real time and adjust the underlying basket accordingly. 

In recent years, index providers have worked with ETF issuers to create unique products that offer specific exposures and index methodologies. Creating custom indexes has been one way for issuers to differentiate from their competitors, many of whom are likely licensing legacy-type indices (e.g., beta, Value/Growth styles, etc.) from “the big four” index vendors: Bloomberg, FTSE Russell, MSCI, and SPDJI.

A good index partner can reflect a product view through a unique methodology used to select specific securities. Ideally, they can also find creative approaches to complicated problems and think outside the box. They must be organized and efficient enough to competently track, maintain, rebalance, and comply with regulatory guidelines while working with authorized participants. 

Additionally, a good index partner provides transparency about their process and is responsive and communicative with the ETF issuer. Because issuers must manage and operate the fund, they need an index partner who can quietly and effectively handle the indexing, which includes methodology development and calculations.

How does an ETF index service provider influence performance?

ETF index service providers can impact many performance markers for an ETF. Notably, they are responsible for any tracking errors that arise through index design or turnover. 

Their services complement fund administration efforts, and their chosen rebalancing frequency and reconstitution schedules can impact an ETF’s net asset value calculations and bottom line. The methodologies used to create the investment universe of a given ETF index can also impact ETF shares’ overall performance, including total cost of ownership, second market liquidity, and trading costs. 

A fund’s performance is ultimately on the management team and any portfolio management decisions, but having a capable index partner can prevent unforced errors and strengthen results. Many index partnerships begin and end at an agreement to license an index, but a good partner can go further and help throughout the full lifecycle of the product.

Key criteria when choosing an ETF index service provider 

Before choosing an ETF index service provider, investment management firms should consider the following: 

Backtests are a critical component of building a smart product that innovates for investors. Seeing how a product would have performed in specific circumstances can let fund managers understand and anticipate how investors will deploy their products, and where there could be opportunities or challenges given market conditions. 

Many index service providers will need time to turn around a backtest. A faster partner can help fund managers iterate and evolve their product ideas. "The Index Product development cycle is iterative by nature,” VettaFi’s Brian Coco said.  “Achieving success requires failing faster." Quick turnaround times on backtests can allow issuers to test and discard ideas rapidly as they work toward meeting product goals.

Finally, when choosing the right index partner, ensure that you:

Questions to ask potential ETF index partners

There’s a lot to consider when choosing a service provider.

Asset managers should ask potential partners these seven questions to help them decide if the partnership will be a great fit.

What unique data sets so you use? 

If you want to build a product that stands out, having access to unique data sets can help make that happen. Index providers with unique data sets can help issuers build products they can’t build on their own.

How can your index help me improve my investment offerings and meet my investment objectives? 

Listening to an index partner explain why they do what they do, and what they believe their value proposition is, can help you assess if they can meet your needs.

What index-specific support will you provide throughout the index-licensing relationship? 

Given how crowded the ETF field is, any differentiation can be an asset. Many index providers only offer basic levels of support and become the “set it and forget it” type of financial services. However, a good partner will be responsive and have digital marketing capabilities to help the fund grow its AUM.

How does your governance committee handle methodology changes, and what is the communication process? 

Clear communication is critical in any enterprise, and ensuring an index partner is transparent about methodology changes can help keep the partnership aware and aligned..

What is your index reconstitution process, and how do you reduce market impact? 

Any given product will express a market view and influence allocation decisions. Accordingly, an index must constantly adjust and iterate based on current market realities. 

How do you ensure consistent index calculations when the market experiences a disruption? 

A good index partner will have a playbook for dealing with all sorts of market volatility and make well-considered, data-driven decisions.

Common pitfalls when choosing an ETF index service provider

Asset managers can run into some of the following challenges when choosing an index partner. 

Two common pitfalls to avoid

The number-one challenge when choosing an ETF index service provider? Failing to thoroughly examine an ETF index service provider’s index construction methodology. 

Misunderstanding their methodology can create issues for the fund manager and greatly impact your investment strategy.

Another extremely common misstep is to choose an index partner who barely collaborates. Once a product has been built, you want an index partner who will throw their all into making the product launch a success. 

What else should you consider when choosing a service provider?

Issuers must walk a line when they consider ETF index partnerships. On the one hand, they need to make sure they are partnering with someone who understands the specific market sector their product will be built around. On the other hand, you also need an index partner with a wide range of indices. 

Suppose you’re building a specific equities product for one sector of the domestic market. In that case, you want an index service partner who deeply understands that market and has indices that include fixed income benchmarks and international exposures. 

A wide range of indices indicates better data sets and enhanced capabilities. However, they also need to have some measure of understanding of the specific market segment you are trying to capture. Finding a partner who is both a specialist and a generalist can be challenging, but it’s not impossible. 

Additionally, issuers will want to make sure that there are no conflicts of interest with how an index is governed, including relationships with subsidiaries. When looking at methodology and construction, you also want to be on the lookout for concentration risks or opaqueness on the part of the potential ETF index partner. 

Conclusion

Launching a new ETF is a high-stakes event. Historically, ETF index service providers have been checked out of the process. That approach made more sense in an era when the ETF was a new wrapper, there was less competition,and requirements of the indices needed were much less complex, mostly broad, beta datasets.

But now, ETFs are a dominant force in the ETF market and competition for AUM is fierce. An index provider must be committed to the success of the products using their indices.

Given the complexity of the ETF ecosystem, it’s critical to find a suitable ETF index partnership. Issuers need responsive, flexible index partners who can contribute to a product’s success on multiple fronts. 

There’s more to it than just licensing a benchmark, and the issuers that take the time to find a real partner will position their ETF business to take a bigger portion of market share and improve the odds that the product will capture AUM and grow.

VettaFi offers a unique suite of index services within the financial services industry, with the ability to be a partner throughout the product’s lifecycle. Learn more now.

 

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