Vanguard, Morgan Ink Index-Licensing Deal
September 9, 2002
Index fund giant Vanguard Group of Valley Forge, Pa., is the first to ink a licensing deal to track a new set of 14 equity indexes that Morgan Stanley Capital International (MSCI) of New York is debuting next year.
The new indexes are among the first from MSCI, a separate but affiliated company of investment banking firm Morgan Stanley, to cover the U.S. equity market. The firm now offers one U.S. country index, as well as an index covering North America. But MSCI is best known for its global fixed-income indexes, as well as three widely used global equity indexes, including the broad-based MSCI World Index, and the MSCI EAFE Index, which tracks the markets of Europe, Australia and the Far East.
MSCI has been making a play for the U.S. equity index market. In July, MSCI debuted a family of 90 hedge-fund indexes that slice and dice information from 750 hedge funds. "Our objective is to become the global index provider of choice. We want to create a one-stop-shopping platform for all of our indexes and utilize the same coherent methods and index compilation we use with our international indexes," said Rabbe Ekholm, managing director and marketing director of MSCI.
The arrangement with Vanguard could significantly jump-start MSCI's attempts to carve out a niche for itself as a U.S. equity index provider, pitting it against industry veteran giants including Standard & Poor's, a unit of McGraw-Hill of New York, manager of the ubiquitous S&P 500. Another significant index provider is Wilshire Associates of Santa Monica, Calif, proprietor of the Wilshire 5000 Total Stock Market Index, and Frank Russell Company of Tacoma, Wash., founder of several small-cap indexes including the Russell 2000.
Indeed, having Vanguard as the sponsor of 29 index funds with a total $200 billion in assets give a nod to indexes even before their launch is a feather in MSCI's cap.
Moreover, given Vanguard's massive index fund assets, the flagship deal could prove extremely lucrative to MSCI, netting it millions of dollars annually in licensing fees. Although details of the agreement were not disclosed, most index licensing agreements are structured such that the index proprietor is paid a fee equal to a small percentage of the underlying index fund's assets. Licensing fees equal to greater than one basis point are quite common, according to one industry source.
While the precise fee Vanguard will pay MSCI is unknown, a conservative estimate of just one basis point would earn MSCI $2.42 million in licensing fees on just the Vanguard Total Stock Market Index Fund, the industry's third-largest index fund with $24.2 billion in assets. That doesn't even include Vanguard's exchange-traded VIPER shares. Assuming a similar fee arrangement on the smaller $4.5 billion Vanguard Extended Market Index Fund, MSCI could pocket another $450,000.
Moreover, fund managers who don't necessarily want to replicate the new indexes but who want a new index against which they could benchmark their actively managed funds, could enter into a data-purchasing agreement with MSCI, whereby MSCI would charge an ongoing fee to detail what its proprietary indexes include.
On Aug. 26, Vanguard filed a shareholder proxy with the Securities and Exchange Commission which, among other things, asked shareholders to authorize the board of directors of the Vanguard fund to consider switching the underlying fund that eight of its index funds now track. Vanguard trustees already possess the authority to switch the parallel index on 19 other Vanguard funds.
Even if shareholders approve the MSCI index substitution at the Dec. 3 meeting, it doesn't mean the funds' trustees will automatically adopt the new MSCI indexes, said Brian Mattes, a Vanguard principal. It just gives the board the flexibility to change a fund's respective index if it deems it appropriate.
Moreover, while Vanguard is the first company to sign an agreement to use the new MSCI equity indexes, the agreement is non-exclusive and non-binding. That means that Vanguard is under no obligation to adopt the new benchmarks, Mattes said.
The group's largest index fund, the $77 billion Vanguard 500 Index Fund, which tracks the S&P 500, is not among those funds seeking a new index, although there is no love lost between Vanguard and S&P.
Two years ago, S&P filed and eventually won a lawsuit against Vanguard, charging that its intended launch of a new exchange-traded VIPER class of shares violated its S&P 500 index licensing agreement originally signed in 1988 [see MFMN 5/7/01, 11/12/01].
MSCI's new lineup of U.S. equity indexes is being created across all three market capitalizations of the U.S. equity market: small-cap, mid-cap and large-cap. Separate growth and value indexes are also on tap. An aggregated total stock market index is also in development, as well as a series of sector equity benchmarks. MSCI will begin rolling out the indexes early next year but declined to say which index would debut first.
Morgan Stanley is billing the new MSCI indexes as "new and improved" because their underlying methodology differs from those of its competitors. They will use eight different variables to more accurately distinguish growth from value companies; employ buffer zones between market segments and styles to prevent unnecessary index turnover when constituent companies temporarily migrate from one sector to another; and objectively decide which companies make the index ranks.
In its shareholder proxy, Vanguard executives admitted that not all indexes are created equal, and detailed the characteristics of an ideal equity index. Vanguard desires an objective method of including or excluding component stocks, a more flexible approach to classifying a company's market cap, as well as labeling it either growth or value. Further, Vanguard wants to rely on indexes with less turnover among component companies. That would hold the line on necessary transaction costs.
Vanguard also wants an index provider that adjusts a company's index weighting based upon its "float," or the actual number of shares offered to the investing public, excluding shares held privately or owned by officers and directors of the firm.