Fidelity and Schwab — which is expected to come out with its own no-cost funds any day now — have brokerage services and other funds that will make up for the loss leaders.
Fidelity’s recent announcement that it was creating mutual funds with a zero-percent expense ratio sounds like a free lunch.
While some people would tell you there is no such thing, others would suggest you take a bite for yourself to see if you like the taste.
Ultimately, investors will like the flavor of zero-fee index funds, but that doesn’t mean investors should rush out after Fido’s new funds like a dog chases a ball.
There is nothing to dislike about Fidelity’s move. It will almost certainly be mimicked by some of the competition, and lower costs are always good for investors.
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But there are a few ways to look at what it means for investors generally, and then some math that individuals should run to decide if the situation is exactly as advertised or a little too good to be true.
To see why, let’s wade into the story of the first zero-expense index funds and Fidelity’s bold new move to capture a bigger share of the market.
Fidelity took the investment world by storm the first week of August, announcing that two new funds — Fidelity Zero Total Market Index (FZIROX) and Fidelity Zero International Index (FZILX) — would open on Aug. 3.
The funds not only carry no costs, they also required no minimum initial investment; it wasn’t just open warfare on the other fund companies that provide index investing, Fidelity is attacking the investment apps like Acorns that effectively promise to invest pocket change and small amounts into index funds for small monthly fees.
Truthfully, the surprise in Fidelity’s move is that the company did such a good job of not telegraphing it, because this has been in the offing for a long time. Fidelity and Schwab — who have been leading the way at cutting costs on index funds — can afford to make a few issues “loss leaders,” the mutual-fund equivalent of the item in the grocery store that is sold for less than it actually costs.
Consumers snap up the loss leaders, but they also buy other goods that are sold at a profit, and the store makes money on the entire order, even if it loses money on one item.
Fidelity and Schwab — which is expected to come out with its own no-cost funds any day now — have brokerage services, other funds and more that will make up for the loss leaders. Both firms have their own networks of funds and have been raising costs on outside companies to be included in those platforms; thus, they’re not sweating a few funds that charge nothing.
A big question here is whether Vanguard and BlackRock — the latter being the power behind the iShares brand of ETFs — will follow suit. It’s a bit trickier for those two giants because indexing — rather than the brokerage business — is at the heart of what they do.
Vanguard, for instance, has always tried to set its expense ratios roughly at cost across the board. It wouldn’t want to make up for a loss leader by charging investors in a different fund more money; fairness is at the core of Vanguard’s ways.
Expect Vanguard to cut fees where it can — and to remain the lowest-cost provider on average — but don’t expect it to go all the way to zero. Ditto BlackRock.
For now, Fidelity shareholders generally should be happy.
Along with introducing the new funds, Fidelity cut fees on many of its index funds by as much as 35 percent. Now they have the free options as a means of diversifying their holdings further.
Anyone who isn’t with Fidelity but who is looking at expanding their index holdings — or who wants to start a small-dollar account to bootstrap their savings — should consider the new issues because the cost structure is the best deal available.
As for whether investors with other fund companies should move money to the new funds, that’s not so clear-cut. A zero-percent expense ratio is better than whatever you’re paying elsewhere, but the savings won’t be big money.
There are plenty of index funds with expense ratios around .04 percent; at that four-hundredths of 1 percent level, the annualized cost of investing $100,000 is about 40 bucks. Even in index funds with expense ratios closer to 0.2 percent, the annual expense dollars are small potatoes unless you invest a boatload of money.
Then there are taxes to consider, if you hold the funds in a taxable account.
Let’s say you invested $10,000 after the financial crisis of 2008 and it since has tripled to $30,000. Your gain is $20,000, and the tax rate on long-term capital gains is 20 percent, meaning you’re going to owe Uncle Sam roughly $4,000.
Remember how you could save 40 bucks by switching from low-cost to no-cost index funds?
Well, the cap gains in this example mean it would take 100 years for the savings to be worth it.
Moreover, the indexes involved matter. Fidelity Zero Total Market uses a proprietary index with 3,000 holdings. By comparison, Vanguard’s Total Stock Market funds are using a different index with 3,600 stocks, while Schwab’s total market index has roughly 2,750 stocks in it.
Academics can argue over which index is better; all an investor cares about is returns.
Vanguard’s Total Stock Market ETF (VTI) has more than double the expense ratio (0.04) of Fidelity Total Market Institutional (FSKTX), for example, but has consistently delivered better returns.
It’s a small performance difference — worth about the same as the cost savings of expense ratios going from near-zero to nothing, so not much to be excited about — but it’s there.
In short, free is good, but it’s not guaranteed to be better.
Ultimately, the free lunch here comes from copycat cost cutting around the industry and for active and passive funds alike. That’s where to chow down; make sure your fund firms are keeping up, and that your portfolio isn’t filled with costly funds when there are low-cost alternatives that could sweeten your retirement savings.