Outside-IN

Fidelity's zero-fee funds unleash the power of free

The asset manager's move will trigger a transformation of the fund industry

Aug 2, 2018 @ 3:16 pm

By Nir Kaissar

Fidelity Investments fired a shot heard around the investing world Wednesday: It announced it would roll out two index mutual funds Friday that charge no fees.

Both funds will track market cap-weighted Fidelity indexes. The Fidelity Zero Total Market Index Fund will invest in the largest 3,000 U.S. companies based on float-adjusted market cap, and the Fidelity Zero International Index Fund will hold the top 90% of stocks within various developed international and emerging countries.

It's tempting to dismiss the move as a marketing stunt. Fidelity doesn't need the money. I counted more than 1,000 Fidelity mutual funds, including the various share classes, with close to $1.9 trillion in assets and an asset-weighted average expense ratio of 0.46 percent a year. That translates into roughly $9 billion of annual revenue.

And that's just the beginning because Fidelity does more than manage mutual funds. As Russel Kinnel, director of manager research at Morningstar, told Bloomberg News, "Fidelity has lots of ways to make money from customers once they are in the door."

Also, only so many firms have the scale to follow Fidelity's lead. And many that do, such as Vanguard Group, BlackRock Inc. and Charles Schwab Corp., already offer comparably priced funds. The Schwab Total Stock Market Index Fund, for example, charges 0.03% a year, and the Schwab International Index Fund charges 0.06%.

The difference between 0.03% and zero, however, will prove to be bigger than three basis points. Yes, cheap is great, but free is irresistible, particularly in an industry notorious for gouging its customers. The funds will sell themselves — as I'm sure Fidelity intends — and competitors will eventually have to follow.

The knock-on effects will be significant. For starters, index funds will no longer tolerate paying license fees to index providers for market cap-weighted indexes such as the S&P 500 Index or the Russell 2000 Index. Index providers will have to waive those license fees or watch their iconic indexes become increasingly sidelined when fund companies create their own indexes, as Fidelity is doing and as Schwab and State Street Global Advisors have already done.

(More: Invesco joins the do-it-yourself indexing trend)

That doesn't mean index providers will be poorer. On the contrary, the index explosion will continue as index providers race to create ever more specialized indexes that imitate hedge fund strategies and traditional active styles, and cater to investors' growing interest in socially responsible investing.

The funds that license those indexes will continue to displace hedge funds and traditional active managers, including those at Fidelity. They'll charge far less than traditional managers for nearly identical strategies, but comfortably more than zero. The asset-weighted average expense ratio for smart beta mutual funds and exchange-traded funds — index funds that mimic traditional active strategies such as value, quality and momentum — is 0.23% a year, according to Morningstar data. That's more than enough to pay index providers their license fees.

As a result, portfolio construction will become increasingly complicated. Many investors will struggle to assemble a portfolio from the huge variety of index funds. The fees they once paid to fund managers will go to asset allocators, although they, too, will have to reduce fees. (Disclosure: My asset-management firm offers asset-allocation strategies.)

At the same time, do-it-yourself investors who are content to buy the market will be big winners, and they're in good company. Warren Buffett has famously said that 90% of the money he leaves to his wife will be invested in an S&P 500 index fund. For the first time, investors can keep the bounty of that portfolio — or a globally diversified equivalent — all to themselves.

The biggest change will be to retirement plans such as 401(k)s, 403(b)s and other defined-contribution plans. Participants in those plans will demand to know why they pay so much for funds that are free elsewhere. The asset-weighted average expense ratio of retirement share class mutual funds is a whopping 0.61% a year. Retirement plans will be forced to slash fees — a long overdue boon to retirement savers.

Mark the date Aug. 1, 2018. It's the day fund fees became a big deal to more than industry observers and investing buffs, to transformative effect.

(More: Vanguard crushed active investing. Now it could save it)

Nir Kaissar is a Bloomberg Gadfly columnist.

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