The SPDR S&P 500 Index (SPY 0.07%) is the largest exchange-traded fund on earth. Managed by State Street, it has nearly a quarter-trillion dollars of assets under management.
But when it comes time to divvy up the management fees charged on this popular ETF, S&P Global (SPGI 2.10%), the owner of the S&P 500 index, is likely the happiest with its haul.
S&P Global is smiling because nearly a third of all fund expenses flow directly into its pocket. The ETF pays S&P Global a licensing fee of 0.03% of assets under management (AUM), plus an annual fee of $600,000, for the right to use the S&P 500 name and duplicate the index with its ETF, according to its annual reports.
Index funds are paying hundreds of millions of dollars in licensing fees to use popular stock and bond indexes. Image source: Getty Images.
A seemingly small fee can add up to huge sums. At the current level of AUM, the fund will pay S&P Global $72 million in licensing fees each year. It's remarkable, especially given that S&P Global doesn't do the heavy lifting. The actual costs of fund management, full-page ads in trade publications like Barron's, and other expenses are borne entirely out of State Street's 0.065% annual take, after licensing fees are paid to S&P Global.
Before the boom
Index funds weren't always a big business, and S&P didn't always know just how valuable the indexes it owned really were. Before the first ETF ever hit the market, S&P agreed to a perpetual license with Vanguard that entitled the index owner to a maximum annual fee of $50,000 from Vanguard's premier index mutual fund, the Vanguard 500 Index Fund.
As Vanguard popularized the index fund, S&P began to realize just how much it had left on the table. By 2001, the Vanguard fund had $90 billion in assets, and S&P was upset with how little the fund was paying to use its namesake index. S&P wanted to link the level of licensing payments to the fund's size, but for obvious reasons, Vanguard wanted little to do with such an arrangement.
But then Vanguard overstepped the boundaries of its agreement. The fund company pushed forward to create ETFs based on S&P indexes with the presumption that its perpetual license would extend to ETFs, too. S&P didn't see eye to eye with Vanguard, and the two landed in court, where Vanguard ultimately lost. To this day, Vanguard's premier S&P 500 index fund is reportedly operating under its perpetual license, paying just $50,000 per year to S&P Global, but subsequent funds based on S&P's indexes are likely paying full freight. For S&P, it was a very costly lesson to learn.
A high-margin business
S&P Global generated $108 million in "asset-linked fees" during the first quarter of 2017, primarily from ETFs based on its indexes. Those ETFs held more than $1.1 trillion of assets at the end of the quarter, which pins the asset-linked fees at an average rate of about 0.04% of assets annually. It collects a smaller amount of fees on derivative products and subscription licenses.
The figures correspond with disclosure from a number of State Street ETFs, which reportedly pay variable fees equal to 0.03% of assets, some with break points at a certain scale. Popular sector ETFs disclose that they pay 0.03% each year on all assets up to $50 billion, with a 0.02% annual fee levied on each dollar of AUM beyond the $50 billion mark.
Interestingly, as the fee war in index fund wages on, it may be the index makers that ultimately decide just how low expense ratios can go. The likes of S&P Global and MSCI (MSCI 1.72%) have little interest in lowering their take. Vanguard famously dumped MSCI in 2012, when the fund company found it could lower its expense ratios on popular foreign stock index funds if it switched its MSCI-based products to FTSE indexes. Today, BlackRock's ETFs are MSCI's single-largest revenue driver, making up about 10% of its total revenue, according to the index provider's most recent annual report.
But other than Vanguard's rare decision to move to a new index provider, the index owners have seemingly faced very little pushback from fund companies, even as expense ratios plunge toward zero.
In truth, ETFs are becoming so cheap that the differences are marginal at best. Only 5.5 basis points (0.055%) separate the highest-cost S&P 500 ETF from the lowest-cost one. At that point, it's a rounding error for everyone -- except for the index owners of the world, who generate hundreds of millions of dollars in profit one basis point at a time.
