[turc1656]

I work in this industry. I'm on the indexing side of it, not the ETF/fund side. We obviously have relationships with all the major fund providers, especially the three big names mentioned in the article. And I happen to work for the big dog - S&P.

"Why? Partly because of two high barriers to entry: the huge scale enjoyed by the big indexers would be difficult to replicate by new entrants; and index fund prices (their expense ratios, or fees) have been driven to commodity-like levels, even to zero."

I can attest that is absolutely 100% true. This business structure is perfect when economies of scale come into play. And S&P is a master of this. It's extremely difficult for others to compete with us because, like everything else, there is a range of services/quality. S&P is at the top end - the Mercedes of index providers. People pay more, but they get the best service/products. The margins are extremely high for any business. But for an service that is considered to have been "commoditized" (and it has to a large extent), our margins are insane. All our competitors want to attack those margins but they have trouble because they aren't able to provide the quality, variety, or depth of service that we do. Which leaves them only able to charge much less and be on the lower end of pricing. Time and time again I've seen some clients leave to go with someone cheaper and become displeased and end up coming back. That's because they simply don't have the internal systems, data contracts, or expertise from having been doing this for as long as we have.

Another thing is that the business model in general is damn near unbeatable. The 500 and DJIA combined require very little work overall as they are just two out of thousands of products we have. But they account for hundreds of millions of dollars in revenue. That's sort of like having a hit movie or book. But the difference with this business model as opposed to most other areas of capitalism is that the revenue is recurring. No where else have I seen unpatented, non-copyrighted intellectual property retain its value like this. Usually there is a surge at the start and then it tapers off fast after release/purchase. That creates a cash cow which they use to build stronger infrastructure and stay at the top.

That being said, let me address the main concern of the article - the issue of ownership for the index funds (not the index providers). I might very well be missing something here, but the answer seems obvious to me. They should just update the law so that the shares owned by the fund providers aren't considered theirs but rather the end holders of the ETFs/funds that they are packaged into. In fact this is so obvious to me I don't understand how it's not already the law since that's the case for a lot of other things like this. If you have a Charles Schwab account and issue an order for a buy, they buy it for you by placing the order under their trading ID on the market. You are later updated to be a holder of record during the trade settlement process. Schwab is a service/pass-through agent. It's very similar for the fund providers. They just buy the shares to package/securitize in advance and then sell to someone. This is the creation/redemption aspect of ETF management. When the creation/redemption process goes on or ETF shares change hands, a process similar to becoming a holder of record through trade settlement should occur. Yes, that would result in you technically being listed as owner of a fractional amount of shares, but that's a hell of a lot better (and easier to deal with) than saying that the fund provider owns all the shares and you just trust them to vote properly for you.

[bulletsvshumans]

I don't want to vote for each of the thousands of stocks I own indirectly through my index fund. I want Vanguard to vote on my behalf such that it proportionately replicates the votes of the non-index shareholders. This strategy is just an extension of the idea behind index funds in the first place: mirror the existing market.

[zAy0LfpBZLC8mAC]

In other words: You want them to not vote at all.

Which is a dumb idea, of course, as that just leaves the control over your capital to your adversaries. Passive investing works because goals are aligned: The only way to influence an index fund on the investing side of things into doing something stupid is by doing something stupid yourself. If you want to make an S&P500 index fund buy some penny stock, you have to buy it yourself first in massive quantities paying massive prices for it to drive up the market cap. Voting does not work that way.

[bluGill]

No, I want Vanguard to hire an independent expert for each company I'm invested in and make the right decisions for me. It is not possible for a human to make an informed decision on voting for each of the thousands of stocks out there. That is one advantage of the fund is they can do that for me.

I have noticed when I vote the shares of the few shares I own that I'm almost always voting with the board of directors. When I've seen a proposal the directors have recommended a No vote on it is always some activist who has their own interests in mind at the expense of me. Sometimes the directors recommend things I disagree with, but those are generally minor details where either way is not harmful to my interests.

[bulletsvshumans]

The other stockholders are almost never your adversaries. Their interests are in alignment with yours: to vote in such a way that it maximizes the value of the stock.

The only exception would be some kind of action that is specifically discriminatory towards your shares over theirs, which is typically not legal. If it were to occur, that is the only situation where I would want Vanguard to be voting on my behalf.

You're right though that not voting is equivalent and much easier than trying to replicate votes.

[zAy0LfpBZLC8mAC]

> The other stockholders are almost never your adversaries. Their interests are in alignment with yours: to vote in such a way that it maximizes the value of the stock.

Nope. Their interest is to vote in such a way that it maximizes the value of their portfolio. If that doesn't match your portfolio, then your interests are not aligned.

> The only exception would be some kind of action that is specifically discriminatory towards your shares over theirs, which is typically not legal.

There is nothing discriminatory about voting for selling a division of company A to company B, say, and it is certainly not illegal. But it might well still be in the interest of the owners of company B who also happen to hold the only voting 10% of company A, and to the detriment of the owners of the other 90% of company A.

[turc1656]

Interesting idea. But you could never know in advance what the results of a vote would be. The only way to do this would be another alteration to law to allow such behavior. However, I am fairly certain this would violate the capital structure and foundational rules put in place by companies with regards to what constitutes a quorum, when/how voting is done, etc. Because companies are allowed to determine how things are done so this would be directly overriding that.

I suppose it's possible to construct a law that says companies can conduct their voting as they have been, but they must also allow/accept late "votes" from fund managers but the requirement is that those late votes must conform to the same proportions.

[kolbe]

How would you handle the fractional share ownership concept? A person with $10,000 of SPY shares probably doesn't even own a full share of most components[1]. And even ones that she does own more than a share of like AAPL, it won't be an integer.

[1] for example, you would need a $270,000 investment before you own a full share of SRCL.

[turc1656]

People are used to thinking of votes in terms of integers, but if you think of it in terms of points then fractions don't make a difference, really. If you own 100 shares of a stock you get to 100 votes. That's been the standard forever. This is just extending it to say that if you own .01 shares you get .01 votes. It's still the same concept and same math, just not on an integer basis.

[gomox]

I find your comment fascinating but even though I think I understand perfectly what an index fund is, I don't quite understand what it is that S&P sells for so much money.

Could you clarify this for me? I.e. who buys from you, and what is it they buy?

[jkulubya]

I think the comment is referring to the canonical list of the constituent securities of an index such as the S&P 500 or DJIA. You pay license fees to S&P to name any fund you create “S&P XYZ Fund”.

I suspect you could legally create a fund with the constituents of the S&P 500 without paying them, but you wouldn’t be able to advertise that fact easily.

[turc1656]

You would not be able to legally recreate the 500 and just not use the name. We once had a problem within our Custom division (where clients retain the IP but pay us to do everything for them) and one client basically created something that was substantially similar in rules/methodology to another client's product and one client sued the other. Our employees were called to present testimony in court but it was settled before it got that far, presumably because the offending client realized they were going to get hammered.

[jkulubya]

I’ve read your other comments in this thread and I mostly follow and agree. I’m getting lost on this one though.

How does this monopoly(?) on the 500 work? Aren’t I able to go out tomorrow and buy the different input securities of an index, and market that as “jkulubya’s awesome fund wink wink”? (Easier said than done)

One wrinkle I see with this scheme is that I probably have to publish my own index value because yours is your ip.

[turc1656]

Think of the 500 (or any index strategy) as being like a story and the methodology is like the book that tells the story. You can't rip off our story and write your own book that essentially plagiarizes the 500 and claim it as your own. If you were to, for example, write a story about a rich kid who's parents were murdered and when he grew up he became a vigilante who wore a disguise to conceal his identity and worked with the chief of police to fight corruption in his city, I have a feeling you might get sued. This happens in the movie industry from time to time. That's why script readers are exceedingly careful on what they read because there have been a number of cases where someone submits a story which then gets passed along but eventually passed-on and then a while later the studio ends up making a movie written by someone else who submitted a scrip with similar story elements and the studio gets sued by the first writer claiming they ripped them off and just paid someone else to rewrite their story. Sometimes it's true, sometimes it's not.

The reason this same legal principal applies to index products is because it's surprisingly difficult to even match an index's composition and weighting even with the methodology document in hand. So the odds of you creating your own strategy and that just so happens to be damn near identical to another index is essentially impossible. So just like the entertainment businesses, they look at it on a case by case basis and examine whether or not the "spirit" of the strategy has been violated or it's creative elements have been stolen. It's done case by case because it can get pretty nuanced and subjective just like music, books, and films.

[jkulubya]

Thanks for this

[turc1656]

jkulubya's comment is largely correct. And you most likely do understand what an index fund is. It's just that most people don't realize there are two sides to the product - the theoretical and the real. The index is a theoretical product (intellectual property). The fund is the real-world implementation. A fund manager takes a look at one of our S&P products and says "I want to make a fund off this" and S&P contracts a license with them to allow it since S&P owns the IP on that index - it is S&P's design and methodology.

An easy way to think of this is the retail example where you pay an investment advisor. You pay them to manage your money but they place all the trades through some broker. S&P is the investment advisor and the fund manager is the broker.

[gomox]

Very interesting. I always assumed that the SP500 index composition was some sort of loss leader for SP where the brand awareness created by the SP500 name served as proof of legitimacy for some other service.

Never thought the index composition could be a cash cow in itself. Im intrigued at how the IP is protected, in legal terms (i.e. what exactly is copyrighted or patented or trademarked or trade secrets), if you are able to comment on that aspect?

[turc1656]

I think my other comment to someone else in this thread addresses most of what you are asking: https://news.ycombinator.com/item?id=18572584

Anything deeper would require an actual lawyer to weigh in.

[mruts]

The S&P 500, along with a lot of their other products are proprietary and not easily reproducible. S&P doesn’t publish how it generates its indices, so they can charge a lot of money.

Would it be that hard to generate an index that had similiar exposure as an S&P index? Maybe not, but S&P is good at what they do and they have a lot of brand recognition.

[turc1656]

This isn't exactly accurate. One of the requirements for publicly traded funds (ETFs) is that they need to be "replicable", meaning that anyone should be able to read the methodologies (which are required to be public) and understand it and be able to come to the same final basket of securities at the same weights.

This, in practice, is very difficult even with everything public, though, due to a variety of differences such as data differences between vendors, "expert judgment" for unforeseen circumstances, and the mere fact that sometimes methodologies can be confusing, complex, or have vague language. Most indices, unlike the 500, are pretty hard on rules. The 500 is a rare index that is purely discretionary. They do give guidance on general guidelines, though.