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The Race To ‘Zero’ Expenses

Fidelity Investments logo on a horse jump hurdle (detail)
photo by Paul Keleher

Industry insiders have long observed that investment firms were “racing to zero” where mutual fund fees were concerned. That race is over – or at least the first runner has crossed the finish line.

Mutual fund expense ratios (the amount investors pay companies to administer a fund) have been falling for years. According to the Wall Street Journal, the average annual mutual fund fee has fallen by more than a third since 2000. More recently, the average expense ratio for mutual funds dropped 8 percent from 2016 to 2017, which represented an estimated $4 billion in savings for investors, according to data from Morningstar. This downward trend has moved in tandem with the wider shift of moving away from actively managed funds and toward passive indexing investment strategies, which tend to have lower expense ratios.

Fidelity Investments was the firm to cross this “race to zero” finish line. On August 3, the company launched two new index mutual funds with annual expense ratios of 0 percent. The two funds are Fidelity ZERO Total International Index Fund and Fidelity ZERO Total Market Index Fund. This branding is reminiscent of Coke Zero, which recently course-corrected due to consumers’ confusion over what the “zero” meant; thus the beverage became “Coke Zero Sugar.” If investors demonstrate similar confusion, I won’t be surprised if Fidelity rebrands the funds “ZERO Expense Ratio.”

The idea of a loss leader is nothing new in the business world. A company may choose to offer a product or service at a deep discount or for free in order to attract customers who will then spend money on the company’s other, higher-margin offerings. Fidelity, as a privately held company, has the advantage of not needing to answer to shareholders on quarterly earnings calls or to react to the constant pressure of near-term stock price performance.

According to the fund prospectus, Fidelity will cover all of the costs of administering these new funds. Fidelity will hire a third-party company, called a sub-adviser, to manage them. The use of sub-advisers is common in the industry. Typically the fund pays the sub-adviser out of the management fees paid by investors. However, in this case Fidelity itself, not the funds, will pay the sub-adviser. Per the management agreement, Fidelity will pay the sub-adviser an annual fee equal to 0.0525 percent and 0.0125 percent of the average net asset values of the Fidelity ZERO Total International Index Fund and the Fidelity ZERO Total Market Index Fund, respectively.

Fidelity presumably hopes to cover these costs by generating other revenue from higher-margin services. The new funds will only be available to investors who have a Fidelity brokerage account, so offering the new funds is Fidelity’s way of getting customers in the door. Effectively, we can view the cost of running these funds as marketing expenses.

The new funds’ sub-adviser will also use Fidelity’s trading desk to buy and sell the underlying securities inside the funds. Thus the funds’ trading costs will go to Fidelity’s brokerage services business. All mutual funds incur trading costs in addition to the expense ratio, so this is not a red flag for investors. However, to the extent these new funds attract new assets, Fidelity will earn new incremental revenue from the additional trading activity.

Fidelity will also likely earn some income by lending securities from the funds to broker-dealers and other investors. The practice of mutual funds lending securities is not new. Many funds throughout the industry currently engage in the practice and have for years. Larger funds with relatively low turnover, such as exchange-traded funds and index mutual funds, are the most likely types of funds to lend securities. The nature of their portfolios allow these funds to loan out more securities for longer periods of time, making them a favored counterparty and allowing them to obtain the best terms for their loans.

In fact, fund companies have come to realize that they can generate a relatively high portion of income from nonfee sources. In fiscal 2017, the Vanguard Total Stock Market Index Fund earned more than 63 percent of its expenses back by income generated from lending out securities. This tactic allows funds to offer a lower expense ratio to investors while still covering some or all of the costs of running the fund.

It works this way: When a mutual fund lends out securities, it uses a lending agent to manage the securities lending activity. This agent collects a fee for its services. Larger fund sponsors, including Fidelity, use in-house affiliated lending agents. The fund receives cash collateral in return for lending out securities, and it usually invests this cash in money market funds or other short-term cash investments to earn income. The fund pays the agent fee out of this extra income, and any leftover gains accrue to the fund’s investors. Sometimes the borrower also pays a direct fee to the lending agent.

By using an affiliated lending agent, Fidelity will receive some “backdoor” revenue from securities lending agent fees, even with the funds’ stated zero expense ratio. But fund investors will still receive some benefit from the lending too, in the form of a little extra income.

It’s also worth pointing out that Fidelity is not sacrificing much revenue with its zero-expense-ratio funds, even aside from any revenue it might receive from securities lending or additional trading fees. Passive investing accounts for only about 16 percent of Fidelity’s business, a far smaller fraction than its major competitors like Vanguard and BlackRock. In addition, many index funds only charge between 0.10 percent and 0.05 percent (and sometimes even less). So at the top end of 0.10 percent, Fidelity will lose $1 million in revenue for every $1 billion that migrates from a regular index to one of the new zero-cost indexes.

Clearly Fidelity will be able to make up some of this lost revenue through the income it earns from securities lending or additional trading fees. But Fidelity is likely hoping the funds’ real upside will be allowing the company to sell additional higher-margin products to customers who come to Fidelity because of the zero-fee funds.

This move by Fidelity will also pressure competitors that rely more heavily on index funds to give up relatively more corporate revenue if they also choose to offer zero-expense-ratio funds. I expect competitors like Vanguard, BlackRock and Charles Schwab to present similar offerings in short order, even if they stand to lose more than Fidelity by doing so.

Should investors grab this great deal right away? Maybe. But first it is important to understand exactly what the deal involves and, more importantly, how it may fit within your overall investment planning.

Like any investment vehicle, these new funds could be right for some investors, but cannot be right for everyone. When you evaluate a mutual fund – or any investment – you should consider a variety of factors, not only cost. It is equally useful to consider a fund’s liquidity, its tax efficiency or its expected volatility. Yes, it is important to keep fees under control in order to keep them from hobbling a portfolio’s long-term returns. But it is also important to consider how risky the underlying investments are and how they fit in with your long-term investment plan. If you are already invested in a similar index fund and want to switch to owning the new Fidelity funds, you also must be mindful of any potential tax costs. Switching to save a little on fees may not be worth the immediate tax hit.

Even Vanguard, a longtime leader in low-cost mutual funds, has urged investors to focus on factors beyond just cost, because fees on many of its offerings are already a fraction of a percent. For most investors, the real difference between expense ratios of 0.05 percent and 0.03 percent – or 0 percent – is actually negligible.

Investment vehicles are merely the building blocks of investing. Such vehicles, like Fidelity’s new mutual funds, can only compete so much on price. The true means of adding value in the industry today comes from investment advice and comprehensive financial planning, which help investors create and apply a thoughtful, “big picture” approach to putting those building blocks together. There are many goods and services you would not shop for based on price alone; the same should go for your investment choices. And good investment choices cannot be made in isolation. Rather, you should consider those choices in the context of your overall financial planning goals and objectives.

As the investment industry changes and fees on investment vehicles fall, forming long-term relationships with trusted investment advisers is more important than ever. After all, if most funds are cheap or free, how will you pick which of the free funds are the best? Funds may also get more aggressive in lending out securities or making risky maneuvers inside the funds in an effort to generate nonfee revenue. Investors should be wary of such behavior.

Wise investors may reallocate some of the money they save on lower investment vehicle fees toward securing trustworthy and comprehensive financial planning services. Always remember that the real goal of investing is not simply to minimize all fees and expenses, but rather to achieve the final outcome you desire. This means meeting your financial goals, whether they are funding your children’s education, creating a comfortable retirement nest egg, donating to charitable causes or eliminating debt. The investment options you use to reach your goals will change over time, and your approach will likely look different from someone else’s – or it should. Investing in Fidelity’s new funds, and other low- or zero-cost mutual funds, should be a choice you make in pursuit of a specific outcome, not simply because the price is right.

Free is always alluring, but don’t be complacent. Take the time to understand any investment before you dive in and understand how it fits within the context of your overall financial goals.

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