If you’ve ever owned an international index fund, there’s a good chance you’ve quietly been paying MSCI.

Not directly, but through the fund’s expense ratio, the asset manager kicks a sliver of those fees back to MSCI for the right to track its benchmark, which are the gold-standard metrics for measuring many aspects of financial markets globally (similar to the S&P 500’s role in depicting the performance of America’s top companies).

Do that across hundreds of funds and trillions of dollars in assets under management, then layer on futures and options trading built atop the same benchmarks (from which MSCI also earns royalties), and you start to see why this business looks and feels like the ultimate toll road for the passive-investing era.

In our podcast, Daniel and I put it plainly: as financial markets have become more indexed, MSCI has been one of the biggest winners, if not THE biggest.

More below on this highly profitable, capital-light business built on trust, network effects, and the financialization of the global economy.

— Shawn

The Toll Road Behind Passive Investing

Two historical forces made MSCI’s dominance over financial indexes possible.

First was the rise of index funds, as the forces of competition pushed Wall Street toward lower frictional costs and greater simplification. In the 1970s, Vanguard sparked this revolution by launching the first S&P 500 index mutual fund, slowly shifting the industry’s center of gravity from stock-picking to index-tracking — an approach that can largely be automated (enabling fund investors to pay dramatically less in fees).

But you can’t have passive investing without widely accepted standards to “passively” track, opening the door for MSCI and S&P to dramatically increase their clout as 3rd-party index providers.

The second tailwind for MSCI was the derivatives revolution, which gave index providers a second royalty stream: listed futures and options referencing their benchmarks.

Exchanges pay index providers the right to list contracts against their benchmarks, while investors pay to trade those options and futures. Whether you think derivatives are weapons of mass destruction or not, they do require agreed-upon benchmarks to attract liquidity, thereby concentrating activity in one place for investors looking to hedge certain risks or express specific bets.

And for context, roughly $17 trillion in assets are benchmarked to MSCI’s indices, which keeps compounding as financial assets continue to appreciate and as global wealth grows, allowing for more net inflows into investment savings.

Sticky Benchmarks

Once a benchmark becomes the lingua franca for a segment like, say, emerging markets equities, asset managers risk outflows by using less well-known benchmarks. Implicitly, investors place a great deal of faith in indexes assembled by trusted companies like S&P and MSCI, which have been curating and managing various types of indexes for decades.

That dynamic hardens over time as certain indexes become synonymous with the markets they cover (like the S&P 500 for US large caps). Switching costs aren’t just administrative headaches, then — they’re reputational. Anyone could just launch their own index, but it’s the brand name and history of credibility that provide legitimacy to a company like MSCI.

So the elevator pitch is straightforward: MSCI is the standard-setter whose economics scale with global wealth and the amount of wealth tied to its indexes, providing some pretty juicy margins and operating leverage.

As in, the marginal cost to serve another dollar of AUM is near zero, while the revenue share is contractual and recurring, and the brand trust continues to mount as MSCI becomes more entrenched behind the scenes of the global financial system.

That’s how you get margins that look like this:

What MSCI Is (and Why It Matters)

Naturally, MSCI didn’t start as a standalone juggernaut. Its roots trace back to Morgan Stanley’s acquisition of international indexing data and IP in the 1980s, leading to the creation of Morgan Stanley Capital International (MSCI).

The company operated as a subsidiary for years before IPO’ing in 2007. Today, its intellectual property spans something like 300,000 indices across equities, real estate, fixed income, and more. That number sounds comically large until you remember how cheap it is to spin up new, rules-based indices and how few ever become true standards.

The “product,” in plain English, is a rulebook and a brand. Asset managers, banks, and consultants license MSCI’s methodologies and data to build or study strategies using various indexes.

Some want to use mass-market benchmarks (EAFE, EM, factor tilts), while others commission MSCI to create custom indices for specific use cases.

From MSCI’s perspective, there’s some upfront work in defining an index’s rules (like the market cap of companies to be included, the formula for weighting included companies, what cutoffs to make based on profitability or governance, etc.), and then in maintaining the index with the latest data and, for stock indexes, removing disqualified companies or adding in eligible ones, but that can be largely automated.

That’s why the business is so capital-light. Once you’ve built the plumbing and earned the trust, the incremental cost to update and deliver is low, while the value of being the accepted standard is high.

Advisors and CIOs often prefer a third-party benchmark they recognize over an in-house recipe that’s 90% identical but 100% less credible. “We track MSCI’s Emerging Market Stocks Index,” conveys legitimacy in the same way “we track the S&P 500” does in the U.S. That credibility makes investment funds easier to market and easier to own (at the end of the day, investment funds are products like any other that need to be marketed and sold).

As you’ll see below, the two biggest fish in this pond are S&P Global and MSCI, followed by FTSE (owned by the London Stock Exchange Group), Nasdaq, and then a number of smaller index providers:

How MSCI Makes Money Off Indexes

Under the hood, MSCI monetizes its role as a trusted middleman in three ways.

Firstly, via asset-based fees, ETF issuers and other passive vehicles pay a few basis points to license the benchmark index — this is what we’ve primarily discussed so far.

Second is subscriptions. Active managers and consultants pay for access to the underlying index data, such as real-time data on what companies are in an index and in what proportion, as well as data on custom indexes and factor/ESG-based indexes via recurring subscriptions

Last but not least are transaction royalties, where, as mentioned earlier, exchanges pay for the right to list futures and options referencing MSCI’s indices.

These various index-driven revenues are the crown jewel of MSCI’s business, comprising roughly 55% of revenue but driving 70% of operating profit, with MSCI’s other business segments (more on that later) contributing much less to the bottom line. The dynamic is similar to FICO, a company we covered two weeks ago, with its golden-goose Scores segment disproportionately driving profits relative to their software business.

And within MSCI’s index business, about 40% of revenue is asset-based, earning minuscule take rates (around 0.024% of a fund’s AUM) on very large AUMs.

Concerningly, these take-rates have compressed over time as management fees on index funds have trended downward, but, for the time being, this has been more than offset by market appreciation and passive inflows driving the AUM figures higher against which those fee rates are multiplied.

In other words, growing scale has been able to offset fee pressures, especially as investors pull savings from actively managed funds and redirect them into passive ones, while Vanguard has led the investment management industry closer and closer to charging nothing in fees to manage passive ETFs & mutual funds over the last five decades.

Scale Bringeth Customer Concentration

The problem with being tied to the rise of passive investing, beyond the shrinking ice cube of management fees, is the serious degree of customer concentration. Wall Street behemoth BlackRock alone accounts for almost half of MSCI’s asset-based fees and ~10% of company-wide revenue, giving the firm real negotiating leverage over MSCI to push down the royalty rate for index-tracking rights.

Esteemed Harvard Business School professor, Michael Porter, namesake for the Porter’s Five Forces Model that some of you may remember from econ class, would call this “supplier power.”

Whatever you want to call it, being dependent on a few large customers isn’t usually an ideal position to be in. If, for example, BlackRock was unhappy with the fee split they must share with MSCI, they could threaten to switch their index funds (and trillions of dollars in assets under management) to other benchmarks, like those provided by S&P or FTSE, cutting MSCI out altogether, as Vanguard did back in 2012.

And like with Vanguard, that wouldn’t (entirely) be due to their own greed, but simply to stay competitive. If you’re BlackRock, and you charge 0.07% annual fees on a global stock ETF, and Fidelity offers an ETF tracking the same MSCI index but with a management fee of 0.05%, all else being equal, BlackRock would have to cut their fee to stay competitive — this is what you might call a “race to the bottom,” and it’s the equalizing force of capitalism.

You can probably see where I’m going here, but in cutting management fees to remain competitive, BlackRock can either reduce the amount it takes home or try to reduce the amount it has to pay MSCI (which one do you think it’s more inclined to do?)

Point being, while I think MSCI has been, and will likely continue to be, an incredible business, I can’t help but worry about how fees for index funds have been steadily declining for decades (don’t get me wrong this has been great for individual invetors, but less so for MSCI), and what that will mean going forward, especially after passive investing becomes more saturated and the rate of net inflows into index funds levels out.

Anyone Can Make An Index, But That Doesn’t Guarantee It’ll Be Used

With futures and options trading, a benchmark becomes the de facto standard, as exchanges pay to list derivatives on it, and volumes accrue to the benchmark with the deepest liquidity. As we often do in these newsletters, making a flywheel analogy here, in the parlance of Jim Collins, is appropriate: common benchmarks concentrate trading and hedging activity in one place, which improves liquidity, attracting even more trading activity (spinning the flywheel faster), ultimately making the benchmark even harder to dislodge.

Imagine Daniel and I wanted to launch the Intrinsic Value 500 Index starting tomorrow: how on earth would we convince individual investors, asset management firms, regulators, financial advisors, academics, etc., globally to not only take it seriously but switch to using/referencing it in place of the S&P 500, which has been, ya know, an industry standard for almost 70 years (with roots dating back a century).

The S&P 500 is so famous that it has defied the boundaries of financial jargon to become a mainstream cultural reference! Unfortunately for MSCI, the S&P 500 belongs to, well, S&P Global, but the point remains for many other indexes. As I’ve alluded to already, MSCI’s dominance is in indexes outside of the U.S:

MSCI’s Other Segments

Before I spend too much of this newsletter musing on competitive dynamics in passive asset management, we should delve further into the other ways MSCI generates revenue.

Everything at MSCI not directly related to indexing is less special economically, but still meaningful. The Analytics segment, offering risk management, performance attribution, and portfolio tools, runs on subscriptions and represents roughly a quarter of total revenue. It benefits from, and pardon the jargon, workflow stickiness.

As in, when big financial firms onboard hundreds of employees to use MSCI’s analytic tools, switching to a competitor can come with substantial time & financial costs. Yet MSCI is still facing off against stiff competition in FactSet, Bloomberg, S&P’s CapIQ, and BlackRock’s Aladdin.

This is a much lower moat, much less profitable business, which, in my humble opinion, dilutes the company’s overall quality, which isn’t to say it’s a bad business, but it pales in comparison to getting royalties from every index fund that uses one of your indexes (similar to how our Portfolio holding, Universal Music Group, collects royalties whenever songs from their catalog get streamed or performed).

For all the attention it gets from management, you might be surprised that the Sustainability & Climate segment (what most people call the “ESG” portion of MSCI’s business) sits just a bit above 12% of total revenue. MSCI was early to this and now covers 15,000+ entities with 700-plus climate metrics, but growth has cooled, particularly in the U.S., amid political pushback.

MSCI has made a bet that, in the coming years, data on climate emissions, pollution, exposure to environmental regulations, and so on, will be increasingly valuable to investors and corporate decision-makers worldwide, and while the mainstreaming of these considerations in investment management has been slower than hoped, I do think it’s a reasonable bet to make.

Finally, there’s MSCI’s Private Assets Segment, which provides data on private companies & transactions and has been the fastest-growing part of the business for a few years now, but it has the lowest profit margins.

So, as the non-Index pieces outgrow the Index business, they tug down the company’s overall profit margins. And while that might inhibit their ability to expand margins going forward, MSCI has still been able to expand operating profit margins from ~38% in 2015 to nearly 54% today, demonstrating the company’s powerful operating leverage.

Direct Indexing

Beyond customer concentration, declining management fees for index funds, and business mix dilution into less attractive segments, we can’t ignore another looming uncertainty: direct indexing.

Direct indexing flips the standard “buy an ETF” wisdom on its head. Instead of owning a fund that tracks a benchmark, the investor, usually using software tools, buys the underlying stocks in a separately managed account to mimic the benchmark, with the option for more customization by excluding or tilting the holdings in certain ways (e.g., “own the S&P 500 minus tobacco stocks”). You get more control over your investments, sidestep management fees, and can also “harvest taxes” to offset capital gains more precisely.

In other words, you can replicate index exposure without the ETF wrapper, buying stocks in the index directly, in the same proportion as the index, with algorithmic rebalancing being done to keep your portfolio in line with the benchmark index.

Clearly, if dollars migrate from ETFs to direct indexing, that’s a big shift in the status quo, and the question is whether MSCI’s royalties will shrink with the ETF pie?

Bulls would argue that, even in a direct-indexed account, you still need a benchmark and the underlying data that defines “what to own.” If you exclude tobacco from your “S&P-like” exposure, you’re still referencing that index universe; your broker/robo-advisor would still need to license the IP from S&P or MSCI.

So disintermediation of the ETF wrapper doesn’t automatically equate to disintermediation of the index provider. Make of this what you will, but MSCI’s leadership is on record as saying that the opportunity for the index business is “only just beginning,” pointing to growing demand for non-market-cap-based indexes (AI, climate, other thesis-driven tilts) that could thrive in both ETF and direct-index formats.

Direct indexing is still small relative to ETFs, but it isn’t obviously an ETF killer, as it may be primarily attractive to wealthier investors in taxable accounts who can fully exploit customization and tax benefits (direct indexing is much less useful in 401Ks/IRAs that are tax advantaged).

On the low end of possible outcomes, Direct Indexing could remain niche, akin to how the impact of robo-advisors has been more modest than expected, generally leaving the ETF ecosystem (and MSCI’s current royalty streams) intact.

On the other end of the spectrum, mass personalization for affluent, taxable investors could rewire the status quo enough to compress ETF-linked fees further and shift the power dynamics in the industry.

But, as MSCI’s management would tell you, there are already hundreds of billions of dollars in direct-index AUM linked to MSCI indexes, and the company has continued to monetize this with licensing fees, while the overall business has kept chugging along.

It’s difficult, though, to snuff out how different the unit economics are of charging brokerages/roboadvisors a fee for using MSCI indexes as a reference, as opposed to taking a share of the total management-fee pie generated by funds tracking MSCI indexes.

Intuitively, I’d think the economics are less attractive, with fixed fees as opposed to a percentage-based claim on a growing pool of funds, but I’m not certain what will happen here, nor do I think anyone really knows. (If you have insights on how direct indexing will impact the asset management industry and index providers in particular, please email me at [email protected].)

Capital Allocation

Now, let’s move on to the important topics of capital allocation and management compensation.

If you like the leadership mold in William Thorndike’s book, The Outsiders, with owner-operators who think in cash flow and compounding, you’ll appreciate MSCI. The company’s long-tenured CEO, Henry Fernandez, helped build the modern version of MSCI out of Morgan Stanley and has run it since the 2007 IPO. Importantly, he owns a substantial stake (several billion dollars' worth), which ties his fortunes to those of the common shareholder.

On that note, they return roughly one-third of free cash flow via dividends annually, while deploying ~60% of FCF toward repurchases.

And since 2021, that cadence of buybacks has retired nearly 2% of shares annually, effectively returning almost 100% of free cash flow (and sometimes more) to owners in a typical year. As a capital-light IP business, MSCI doesn’t need much reinvestment to sustain the franchise, so this steady “dividends + cannibalization” mix becomes a core part of the compounding engine for shareholders.

It’s not just the amount of buybacks but the timing, too. Management has tended to be more aggressive when the P/E is lower and to throttle back as the valuation stretches — a crude but useful signal that they’re at least price-sensitive in retiring shares. You can see the relationship between heavier repurchases and cheaper multiples here:

The long-term track record backs this up: roughly a third of the share base has been repurchased over the past decade, with $5.8B repurchased at an average price of $117 (versus a current price several multiples higher).

On management incentives, a key consideration for any long-term investor trusting their money to someone else to manage, the mix is decent, but not entirely ideal. Stock-based comp runs about 3.5% of revenue (low-ish but up roughly a third from a 2022 trough).

And equity awards come in two flavors: options vesting over three years (not ideal) and performance-linked stock grants unlocked by total shareholder return (good!).

I dislike restricted stock units that vest over time for senior leaders because I think one’s base salary and performance targets should be enough incentive to “stay.” Corporate leaders shouldn’t be rewarded for simply not leaving. That implicitly incentivizes folks to bide their time, filling an empty seat, simply to collect their owed payout after a certain period.

But I do like that there’s a hard “skin-in-the-game” rule for the CEO, who must own shares worth at least 12× his base salary at all times.

Consistent free cash flow return via dividends & buybacks, valuation-aware repurchases, reasonable (but rising) stock-based comp, durable CEO ownership with skin in the game, and manageable net debt, combine together to paint a pretty favorable picture for MSCI as a consideration for our Intrinsic Value Portfolio.

Valuation

Before I get too fired up about management’s incentives, though, which, again, are pretty good (but could be improved), let’s figure out what is actually a fair price to pay for this company.

You probably won’t be surprised to hear, based on the quality of MSCI’s Index business, that the stock tends to trade at a significant premium to the market.

I don’t really have strong opinions on MSCI’s non-index business units, particularly with Sustainability & Climate and Private Assets.

I see them as extensions of the Analytics business, so really, at its core, MSCI is still about indexes and analytics, and all this analytics stuff, as it grows faster than the index business, drags down the company’s overall profit margins.

So as I tried to model this company, I created a base case where these lower-margin segments continue to outgrow the index business, with the company overall mostly growing in line with what management and analysts have projected.

And partially, that’s probably just laziness on my end, but also, it’s because I don’t have a ton of conviction in MSCI’s future either way. I wasn’t able to fully wrap my head around how things like direct indexing, for example, will weigh on the business going forward, so it’s hard for me to feel confident predicting a scenario that isn’t the status quo.

This is one of those cases where I went through the exercise of doing a valuation just to see if any insights came out of it, but modeling only goes so far if you don’t have a fully formed opinion on the business through a more qualitative lens.

With our portfolio holding Uber, for example, I have a lot of confidence in how their competitive advantages compound as their network effect scales, allowing them to have more drivers in more cities, offering the cheapest rides that attract the most customers, and I can reflect that opinion in a model.

Or with Universal Music Group, I know that streaming platforms and the internet are only increasing the amount of music we all consume, which benefits UMG by earning more royalties on its music catalog.

But when you don’t have a unique opinion to express, there’s not as much to be gained from modeling exercises, unless you’re doing a reverse DCF to see what assumptions are priced into a stock currently.

And with all of our Portfolio companies, these are dynamics I feel that I can pretty intuitively grasp, but not with MSCI. While MSCI’s indexing business has been so great in the past, I’m just not sure it’ll continue to be so good, as the passive investing revolution continues to unfold, and as management fees on index funds continue to come down.

I think it’s very telling that, when making long-term projections for the future, MSCI’s management doesn’t do so for its asset-based fees coming from index funds. If management wants to paint this rosy picture of continued growth going forward, but they caveat that with exceptions for a core part of their indexing business, well, then, again, I don’t know how, as an outside investor, I could have much faith in their projections.

So even if we got the right price, I’m not sure I’d want to actually add MSCI to our Intrinsic Value Portfolio anyway, unless it was just outlandishly cheap.

And long story short, at around $460 per share, that’s where the stock starts to look interesting with something like a 20% margin of safety relative to my fair value estimate in a base case.

Rather than that being the price I’d recommend buying it at, that’s more like the price I’d recommend Daniel and me revisit the stock to see if we can get more comfortable with these variables; otherwise, it should just go in the too-hard basket.

With that, if you want to dive deeper into MSCI, here’s the link to my model and the podcast with Daniel.

Updates on our Portfolio below!

Weekly Update: The Intrinsic Value Portfolio

Notes

• No additions to the Portfolio this week, but we continue to keep our eye on companies we’ve previously covered to see how the valuations fluctuate and how the theses unfold. This past Wednesday, Daniel and I held our monthly call to review our Portfolio together, during which we went through an exercise of ranking the companies on our watch list that we’re most actively interested in after previously covering them.
  

• Here are the companies we’re closest to initiating positions in at current prices, in order: Copart, Ferrari, LVMH, Match Group, Visa, and Crocs.
  

• If we can get just a modestly better price on Copart, we’ll likely add it as a small 2% tracking position in the coming weeks. For Ferrari and LVMH, we’d need something closer to a 15%+ selloff to consider an initial position — same for Visa, too. With Match Group and Crocs, these are more traditional “value” plays that we remain interested in but still have some more room to get comfortable with before opening a long position in them.

Quote of the Day

“Ultimately, nothing should be more important to investors than the ability to sleep soundly at night.”

— Seth Klarman

What Else We’re Into

📺 WATCH: How Nike’s new CEO plans to turn things around

🎧 LISTEN: 10 Lessons from investing legends with Kyle Grieve

📖 READ: Fundsmith’s acclaimed letters to shareholders, packed with value investing insights & wisdom, written by Terry Smith

You can also read our archive of past Intrinsic Value breakdowns, in case you’ve missed any, here — we’ve covered companies ranging from Alphabet to Airbnb, AutoZone, Nintendo, John Deere, Coupang, and more!

Your Thoughts

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