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Looking Past the Fidelity Zero Headlines

Christine Benz
Ben Johnson, CFA

Christine Benz: Hi I'm Christine Benz from Morningstar.com. Fidelity recently announced that it's slashing investment minimums and lowering costs on number of its funds in some cases all the way down to zero. Joining me to discuss the news is Ben Johnson, he's director of passive research strategies at Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me Christine.

Johnson: Ben, let's talk about some of the headlines here, there was a lot of news released by Fidelity yesterday. Let's talk about some of the key things, some of the key changes that they're making especially to their index lineup.

Johnson: The headline without a doubt was that Fidelity is launching a pair of zero-fee index mutual funds. Those funds will be underpinned by Fidelity indexes. They'll have no investment minimums, I can walk up to a Fidelity branch with $1 in theory and invest in one of these funds with an ongoing expense ratio of nothing.

Benz: There is Total U.S. Market Index and a Total International Index, is that right, those are the ones going to zero?

Johnson: Two broad-based market-capitalization-weighted equity indexes. One covering the whole of the U.S. stock market, one covering the rest of the world.

Benz: Then across the lineup they are doing some reduction in fees and also removing minimums from a whole lot of funds.

Johnson: While the zero fee index funds captured all of the headlines, what I would argue is that the nipping and tucking across Fidelity's existing index mutual fund lineup was far more economically significant, certainly for existing shareholders which will now enjoy the lowest pricing available, irrespective of how much they have invested in the fund, irrespective of which share class they're invested in today. Those share classes will ultimately be collapsed into one. The investment minimums on those share classes has also been reduced to zero. I think this is a very beneficial move that opens up institutional level pricing for even the very smallest investors.

Benz: One headline you think kind of got lost in the shuffle was the fact that the firm is expanding its commission-free ETF lineup.

Johnson: That's right, there are so many different bullet points in this announcement it's difficult to keep track of them. I think one that got buried quite deeply was the fact that it's commission-free ETF menu has now expanded from 95 ETFs previously to 240, the bulk of those being added at the margin being iShares ETFs. What you see in sum, is really to put it in its context is a competitive response on Fidelity's part. What we saw if we go back to February of last year is that Schwab made similar moves within its own index mutual fund lineup, repricing a number of those, reducing investment minimums across the board to offer a far more compelling offering that's available to a far larger number of its investors. Schwab's also over the years been gradually expanding its own commission-free ETF menu. More recently what we saw is that Vanguard effectively opened the floodgates on its proprietary commission-free ETF menu offering virtually any ETF that investors on their platform could want to trade on the commission-free basis that's effective as of Aug. 8 of this year.

Benz: The question is--and you've alluded to the fact that there are these huge competitive pressures within this ETF and indexing business--do you think other firms will follow Fidelity down to 0% expense ratio?

Johnson: It's certainly been the case, is that we've seen these frogs leapfrogging one another, headed into, I don't know, a boiling pot of water, at least as is perceived by many as we've gone ever nearer zero with respect to fees on index mutual funds. It'll be interesting to see if predominantly either Schwab or Vanguard respond in kind. I'm most eager to see what the competitive response might be from Vanguard. If you look at the firm's index mutual fund lineup today and the share class structure an the investor share class in particular the minimum investment requirements there and the fees in particular are looking out of step when you consider it in the context of what Schwab and Fidelity have done within their own index mutual fund lineups.

Benz: The minimums are higher, maybe $3,000?

Johnson: $3,000, $10,000 in the case of the Admiral share class. But the fees on that investor share class is in some cases multiples higher than what you might pay for a comparable exposure from one of Vanguard's competitors.

Benz: Let's talk about what's in it for Fidelity, it sounds like keeping up with its competitors was top of mind behind these moves. What does Fidelity stand to gain from the fact that it's going to have some funds on its racks that are essentially loss leaders?

Johnson: What Fidelity's clearly gotten from all of this is loads of great press, free press. That 0% fee headline has been pasted over just about every publication imaginable. We're here talking about it ourselves. It's attracted a lot of attention. And rightfully so, because a zero-fee fund broadly diversified market-cap-weighted indexes in the U.S. and outside, this is inarguably a great thing for a huge number of investors, because the investment minimum is also zero. But economically from Fidelity's point of view this, I would say, is absolutely a loss leader. It's the gallon of milk that's in the refrigerator at the back of the store and Fidelity is counting on the fact that once you walk in and start touring the aisles with your cart that you are going to walk out with more than just a gallon of milk. That you might look at their active mutual funds, that inevitably you might have a cash sweep into one of their money market funds.

Benz: Which are profitable, right?

Johnson: Which are now, I would assume, profitable after many years of having to be sort of subsidized given the low interest-rate environment. For a number of years now, money market funds have kind of been the asset management equivalent of the boomerang Millennial that comes back to live in mom and dad's basement and raid the fridge every now and then. As interest rates have risen, the money market business has become money-making business again. The timing may be purely coincidental, or it may reflect the fact that Fidelity has more wiggle room from an economic point of view to afford to offer these loss leaders at this point in time.

Benz: Fidelity has some pretty good active bond funds as well. That seems like one category where investors haven't completely lost faith in active management is in fixed income.

Johnson: Absolutely the case.

Benz: Let's talk about what's in it for investors. Obviously low fees are good, they are something we want to see, but I guess the question is, investors are paying fees somewhere. It seems that advisors are increasingly taking some of the fees that heretofore had gone into funds. Is something getting lost in terms of accountability and transparency? Let's talk through the positives and the negatives for investors.

Johnson: I think it depends on the investor in question. A self-directed investor that's perfectly comfortable building a simple portfolio for themselves, this is an absolutely fantastic thing. They can do so for now if not nothing next to nothing. I think if there is any real impact that this move will have its psychological in nature in that investors are now coming to expect to pay nothing for broad market exposure, no different than we don't expect to pay to have a checking account. We don't expect to pay for WiFi when we sit down in our local Starbucks …

Benz: In hotel lobby or …

Johnson: Hotel lobby. That's very meaningful. If you zoom out and look more broadly at what we've seen in terms of flows in recent years and the trillions of dollars that have gone into low cost funds of all sorts be it index based or active, this is really reflective of a shift in the economics of advice. There are other investors that are working with an advisor. And those advisors' economics are changing with time as well moving from transaction-led models to fee-based models.

I think of it as sort of a squeezing of the balloon. The air is not being let out of the baloon and it's just going from one segment to another. What's getting squeezed is the cost of the investment products that advisors are using on behalf of their end clients so as to be able to preserve that fee where they earn their keep, how they keep the lights on, how they pay their bills. Now to the extent that those fees might not be uniform, they might not be transparent, you might not be able to compare them as readily as you would fees for investment products--indexed mutual funds, ETFs, funds of all sorts. This can be somewhat concerning, so I think it's important that investors in that context when they're working with an advisor ask some tough questions about how much am I paying you, how am I paying? What am I paying you for?

Benz: What does it look like in dollars and cents I always say.

Johnson: Absolutely. While we certainly need to celebrate the fact that cost of the investments that we're using or an advisor is using on our behalf are drawing ever nearer zero and have hit zero, in pair of cases, it's important to understand that there are other expenses out there that we're going to incur and not to forget the tyranny of compounding costs and what they can do to our overall outcome as investors.

Benz: Ben great insights as always. Thank you so much for being here.

Johnson: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.