Investing Crosses the Rubicon: Free Index Funds
Fidelity's move has more symbolic than economic significance, signifying important shifts underway in the fund industry.
Yesterday, Fidelity Investments unveiled a sweeping set of initiatives that, taken together, make it easier and cheaper to invest in passive funds and exchange-traded funds on its brokerage platform.
The centerpiece of the move was Fidelity’s announcement that it is launching two index funds that will be free to investors: Fidelity Zero Market Index and Fidelity Zero International Index will levy a 0.00% expense ratio apiece. The funds are not subject to other, ancillary charges, the 0% expense ratios aren’t thanks to a fee waiver that could one day be yanked, and there’s no minimum investment. So, Fidelity has thrown the door wide open to investors seeking free access to the broad U.S. and foreign stock markets.
Crossing the Rubicon
The arrival of zero-fee index funds doesn’t come as a complete shock, as pundits have been speculating for some time that indexing would one day become a throw-in. The cost of the cheapest passive funds and ETFs was already hovering just above zero before Fidelity’s move, after all. But it’s still pretty startling to see mutual fund investing cross this particular Rubicon. Indeed, investment products like mutual funds have tended to be viewed not as a means to an end but as a destination unto themselves. If this doesn’t shatter that illusion, it certainly cracks it--Fidelity is using the Zero funds to attract investors and their assets to its brokerage platform. They’re bait.
Yes, it’s true that market-cap indexing is a different kettle of fish altogether: a commodity business won on scale and price, where it makes perfect sense for fees to approach zero. Yet, it’s an open secret in the mutual fund business that many active stock funds charge a premium for delivering what’s basically just broad-market exposure. With Fidelity making that exposure free, it only further widens the gap--if more symbolically, than economically--between what active funds charge and what they ought to charge. And with that will come still more fee pressure, consolidation ... change.
It’ll also reverberate in the passive-investing business, which is increasingly two-tiered. The “haves”--Vanguard, BlackRock, Schwab, State Street, and now Fidelity--boast enormous scale or other assets that they can use to scrape revenue even as investors flock to their lowest-fee products. The “have-nots”--a litany of mostly smaller-scale, niche players--differentiate to levy higher fees, from which they hope to subsist. Free indexing doesn’t significantly alter the fundamentals of that business--as mentioned, the lowest fees were barely above zero before Fidelity’s move. But it reinforces a daunting reality facing upstarts: You adapt or you die.
New “Free,” Same as the Old “Free”?
Industry implications aside, it’s hard to see this as anything but a positive development for investors. If costs are a menace to successful investing, the shift to zero-fee investing defangs it. Investors stand to keep nearly all of what their fund investments earn--the whole enchilada in the case of the Fidelity Zero funds. Hard to argue with that proposition.
All the same, investors should be situation-aware, and here is where they sit: in the midst of a business that’s undergoing a pretty dramatic reordering and transformation. Alpha is being pounded by intense competition into beta; investing is increasingly being supplanted by advice; products are being elbowed aside by more-encompassing “solutions”; and costs are being displaced from one area (the fund) to another (the intermediary/advisor).
Those circumstances notwithstanding, one could reasonably ask what harm could possibly come from free anything. There’s a certain irony in that question given that the seismic shifts we’re seeing--toward lower cost, unbundling, and fee-based advice--are arguably a consequence of trying to rid investors of stand-alone transaction costs and advisor commissions in the first place.
Back in the day, investors loathed these charges, be they brokerage commissions or the “loads” levied on their fund purchases to pay advisors, and therefore sought to avoid them while gaining greater investment choice. This gave birth to No Transaction Fee platforms and embedded “advice” fees (impenetrably labeled "12b-1"), which made it “free” to trade and get advice. In reality, what it did was bury and eternalize these costs--they entered a fund’s expense ratio, never to go away, even if the investor didn’t have to write a check to pay for the convenience and advice they were getting in return.
In that sense, the rise of low-cost, unbundled investing and fee-based advice represents a rejection of the “free” that had dominated as the status quo for years. In effect, this most recent shift to “free”--the zero-fee index fund, for instance--is the culmination of a process that’s seen investors try to separate their alpha from their beta, their investment cost from their transaction cost, and their investments from their planning and advice. They don’t want them mushed together; they want them mercilessly pried apart and priced separately.
But if the old “free” left investors with stubbornly high investment expenses from embedded advice and distribution charges that never scaled, will the new “free”--where they pay a pittance for their investments but incur other external, harder-to-compare costs like wrap charges and advisor fees--have similar unintended consequences? That’s the full circle one doesn’t want to see completed, where costs are diffused but not truly eliminated.
Net-Net: Good News
The good news is that a repeat of the past seems unlikely. And why? In a word, technology. Just as automation has ushered in the rise of low-cost quantitative and passive investing, so too is it likely to enable cheap delivery of advice and dissemination of data and information by which to compare the quality and price of advice.
That process is already well underway, with automated advice programs like Vanguard’s and Schwab’s robos taking off. In addition, services that track advisor fees and disciplinary history are becoming more commonplace. If anything, progress in this area is accelerating, which makes it increasingly likely that the advice business will pass through the same crucible of unbundling and economizing that the fund business has.
The new Fidelity zero-fee index funds don’t represent a quantum-leap in low-cost investing, but they continue to march the industry in a direction that puts investors front and center, where they belong.
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