Zero Cost Funds

Thursday, August 9th, 2018

This is an interesting development: Fidelity has launched two zero cost mutual funds.

The global trend is toward lower expense ratios and fee structures as investors shift more aggressively toward passive management. The idea behind these zero cost funds is that Fidelity can probably use these funds as loss leaders to get more clients and then cross-sell other products to make money.

David Snowball at the Mutual fund Observer comments:

It might even be economically sustainable.

  1. Fidelity isn’t giving up much money. Passive investing accounts for just 16% of Fidelity’s fund business, about $400 billion, a far smaller fraction than many of its competitors. With many broad market cap weighted funds charging 10 bps or less, Fidelity loses $1 million in income for every billion that migrates from a “regular” index to a zero cost index. If these funds attract $40 billion, Fido loses $40 million. It is, meanwhile, pressuring competitors more dependent on index funds to give up more of their corporate income.
  2. Fidelity can make money by lending the funds’ securities to other investors. Professors William A. Birdthistle and Daniel J. Hemel of the University of Chicago College of Law argue that mutual funds are increasingly finding that they can generate income from non-fee sources. In fiscal 2017, the Vanguard Total Stock Market Index Fund earned more than 63% of its expenses by lending securities. The demand for securities loans has limits, but growth in that market will allow an increasing number of funds to offset some or all of their expenses through loan income. (“Next Stop for Mutual-Fund Fees: Zero,” Wall Street Journal, 6/10/2018).
  3. Fidelity, like your grocery, can bank on the fact that you’ll end up buying some high-margin products once they’ve got you in the door. Birdthistle and Hemel predict that “Wise financial institutions will realize that offering a free mutual fund can attract customers to whom they can cross-sell other products, like life insurance and annuities.” Morningstar’s Russel Kinnel pretty much agrees, “Fidelity has lots of ways to make money from customers once they are in the door.

We may even see other brokerage houses following suit. So in this global race to the bottom, who will have the edge and win?

I think this comprehensive report by Morningstar on fee trends gives some good insight:

Asset-weighted fees are lower than equal-weighted fees for nearly all these fund sponsors. That’s consistent with the trend of investment dollars moving toward low-cost funds. It’s also evidenced by the fact that the firms represented in Exhibit 1 control about 94% of U.S. index mutual fund and ETF AUM, but account for a relatively smaller share (80%) of run-rate fee revenue. This also means that there is still room for small players to extract relatively larger fees in niche market segments.

(…)

The trend is clear with respect to fees. On one hand, investors are voting with their feet and moving to low-cost fees. On the other hand, because the least-expensive index mutual funds and ETFs attract the lion’s share of investors’ dollars, comparing fee-level differences as they approach zero becomes an ever less-meaningful endeavor. Don’t get me wrong: Fees are important, but investors should keep their focus on funds with strong investment processes (as defined by the makeup of their underlying indexes and how well portfolio managers can track them). As fees reach the zero bound, the investment process will likely have a greater impact on investment outcomes going forward.

And this also makes a lot of sense. Going from expense ratios of 1 per cent to 0.1 per cent will have a large impact on returns if compounded over time. But given the inherent volatility of markets, the fall from 0.1 to near zero will not have as significant an effect. The difference to end investor returns will be the investment process which they follow and how closely their managers can deliver on their mandates.

India is still to see investors move aggressively toward passive funds. But it is a matter of time; alpha is becoming increasingly difficult to come by in the more efficient segments of the market and regulations are forcing expense ratios lower. It may be a while before we get there, but the trend is clear. Interesting times ahead for investors and for asset managers.


About the author

Rishad is the founder of Kairos Capital. He started his career with Standard Chartered Wealth Management and has extensive experience in markets, particularly in terms of mutual funds and stocks.

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