Fidelity’s no-fee fund triggers mix of alarm and calls for calm
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The economist Milton Friedman coined the adage that there is no such a thing as a free lunch. This month, one of the biggest investment firms decided not only to make lunch free but to throw in dinner as well.
Fidelity, the Boston-based investment group with $2.4tn under management, last week announced that it was cutting the cost of all its passive, index-tracking mutual funds, and introducing two new ones that boasted an expense ratio of zero — in other words, the first free investment funds.
On one hand, this was only a small, natural progression in the intensifying price war that is reshaping the investment industry.
Charles Schwab, Vanguard and BlackRock already offer passive investment vehicles that cost only a few basis points more than Fidelity’s new offerings, and Fidelity only trimmed costs in its index fund suite rather than in the faster-growing exchange traded fund sector.
Nonetheless, the implications are profound: one of the investment industry’s biggest and longest established operators thinks that investors should expect exposure to US blue-chips and international equities — the staples of most portfolios — for nothing.
Coming from an asset manager best known for its long line of well-known stockpickers stretching from Peter Lynch to William Danoff, it is a powerful message.
“These are important building blocks and we want to make it easier for people to invest and stay invested,” said Kathleen Murphy, president of Fidelity Investments’ personal investing business. “I think value matters and it all adds up . . . investors want the money in their pockets, not someone else’s.”
It should be noted that this commitment to value has limits. Fidelity made a record $5.3bn operating profit on revenues of $18.2bn last year and the overall cost of the move on index funds is just $47m. By contrast, Mr Danoff’s $130bn Contrafund generates almost $700m in management fees a year.
Nonetheless, investors were alarmed at the prospect of the price war between asset managers entering an even fiercer phase, sending the shares of competitors such as BlackRock, T Rowe Price, Invesco and Franklin Resources tumbling. The overall S&P 500 asset management index hit its lowest level since November 2017 on Thursday.
There is more than $5tn in so-called large-cap US equity funds and $1.5tn in international-focused funds, according to Morningstar, with average net expense ratios of 1.03 per cent and 1.11 per cent, respectively. Given the difficulty that fund managers have in consistently beating their benchmarks after fees, the concerns are understandable.
Still, the scale of initial fright might have been overdone. Wall Street analysts rushed to push out notes arguing that Fidelity’s move was unlikely to have a noticeable near-term impact, and asset management stocks duly bounced back on Friday to pare their losses for the week to 2.2 per cent.
Goldman Sachs’ Alexander Blostein said that index funds and ETFs were “fundamentally different products” with differences in pricing having little effect on where investors would channel money.
The fees on Charles Schwab’s two index funds that compete directly with Fidelity’s new offering, he pointed out, were already 70-80 per cent lower than Vanguard’s — but Vanguard’s market share in the segment has remained unchanged.
Indeed, although price is the biggest factor for most investors, it is not the only one. For example, State Street’s “SPY” ETF remains the industry’s biggest, despite charging more than the equivalent ETFs from BlackRock, Vanguard or Schwab, because many institutional investors like its liquidity.
Most likely, Fidelity’s move takes a leaf out of how supermarkets will offer some products at a loss to get customers through the door and then try to sell them marked-up organic olive oil or imported beer.
Some revenues can be generated through lending out shares to short-sellers, but attracting new customers was the most plausible economic rationale, said Adam Grealish, an analyst at Betterment. “It’s a bit like lowering the cost of your aeroplane tickets but charging more for carry-on luggage.”
That is why Fidelity’s move was more about competing with brokerages such as Charles Schwab and TD Ameritrade and would have relatively little impact on asset managers, insisted Martin Small, head of BlackRock’s US ETF business. “We have zero plans for zero-cost ETFs.”
Indeed, Mr Small and some analysts say the move could even prove beneficial to BlackRock, as it has been Fidelity’s “preferred ETF partner” since 2013. So inflows into Fidelity’s platform could yet spill over into its products.
But the seismic trend towards lower costs across the entire investment ecosystem is inescapable.
Index funds, ETFs and traditional active mutual funds may be different products but they face the same mounting price pressures — which Fidelity’s decision both reflects and exacerbates — and raises questions over what the next landmark will be.
“Fidelity’s move was the logical conclusion in the price war we’ve seen over the past decade . . . There is a secular trend of compression across the board,” said Mr Grealish. “It’s hard to see investors at some point getting paid to invest but it’s no longer impossible.”
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