Fidelity’s Zero Cost Index Funds – Much Ado About Nothing?

On August 1, 2018, Fidelity Investments, by introducing two zero-management fee index funds, seemingly fired a shot across the bow of the 18th century vessel that is Vanguard’s vaunted logo. For over forty years, Vanguard, the shareholder-owned behemoth has led the way in reducing the cost of investing to a level approaching zero. The Admiral Class shares ($10,000 minimum) of Vanguard’s Total US Stock fund (VTSAX) carry an expense ratio of .04%, or 4 cents per $100.

The move is similar to those recently announced by Fidelity, Vanguard and others to waive commissions on the trading of Exchange Traded Funds (ETF’s). Of course, in the case of ETF’s, the sponsors of those products pay the brokers from the management fee for shelf space on their platforms.

On the surface, it may appear that moving your investments to the “free” option is a no brainer. But as with most consumer decisions, there may be more to the analysis than meets the eye.

No Such Thing as Free

To begin with, it should be obvious that it costs Fidelity something to manage a fund, even a fund that is just trying to match the market-cap weighted returns of an index. And companies don’t stay in business giving away their products and services. So there has to be a catch.

First, this deal is only available on Fidelity’s brokerage platform. One commentator likened this approach to offering free admission to a theme park just to charge exorbitant prices to board your children’s favorite rides.

In marketing terminology this is called upselling from a loss leader. You may have to keep your cash in a relatively expensive money-market account. And watch out for a sales pitch for financial advice, which may not be as inexpensive or valuable as it seems. You might do well to pay attention to the quality and cost of advice being offered, rather than the free product (or dinner – you’ve seen those ads) that lured you in the door. What they giveth with one hand may eventually be taken away with the other.

Another one of the ways Fidelity is supporting these funds is through securities lending to short sellers. Many funds do this, in different ways, generating revenues from the borrowers of shares held in the fund. But securities lending is not a risk free proposition, needs to be done carefully and occasionally backfires.

Moreover, all funds – open-end mutual funds and ETF’s – have costs of ownership associated with them other than the management fee. In some funds these costs border on being insignificant. In others, they may create considerable drag on returns. This article examines those costs in detail.

Not All Indexing is Alike

When the focus is on cost – and only cost – it’s easy to lose sight of the fact that not all index or other passive, index – like products are the same. Just recall how much time you spend comparing seemingly identical rental cars and hotel rooms, with similar prices, when planning a vacation.

As Colorado colleague Allan Roth points out, Vanguard’s Total Market Index Fund is more diversified and more broadly constructed than Fidelity’s new funds, including 654 more small cap companies.

Similarly, in Larry Swedroe’s take on the matter, comparing three passively managed small-cap value funds, he emphasizes the differences in exposure to the investment characteristics the funds are seeking. While the Vanguard fund is cheaper; the DFA and Bridgeway funds compared have greater exposure, by various metrics, to both the small and value factors.

Cost is Important, but isn’t Everything.

John Bogle, one of the founders of Vanguard, once famously said about investing, “You get what you don’t pay for.” Mr. Bogle was talking about the historical return gap between high priced, actively managed funds and index funds. Even if a top-half-of-the-class manager is able to “beat the market” by 1% before costs, if she charges 1.25% for the privilege, you’re behind the 8-ball anyway. So moving from active to passive management and bringing down your fees by 100 or 115 basis points makes a lot of sense.

But we’re talking about something more subtle here. Seeking quantitative sources of risk and return based on decades of academic research and evidence. And whether it might be worth paying 10 or 20 or 30 basis points more than the cheapest fund, not for purported stock picking prowess, but for better structure, better execution and a more targeted and refined approach to capturing the returns of the various asset classes. Only time will tell. But if you’re wrong, the cost certainly won’t hurt you like the cost of active management.

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