Fidelity Investments recently became the first asset manager to announce a zero-fee index fund in the US with the launch of its Fidelity Zero Total Market Index Fund and Fidelity Zero International Index Fund. A relative latecomer to this space, Fidelity has beaten more established rivals such as BlackRock and Vanguard to become the first company to offer such index funds without a management fee.
In what has been an intensifying price war, Fidelity’s latest approach employs similar tactics to those used by supermarkets, whereby selected products are loss making in order to attract new customers onto its platform. Fidelity will then attempt to sell additional products and services to these new customers in order to generate revenues that will more-than-offset the cost of operating the zero-fee index funds.
Part of the cost of operating an index tracker is the license fee paid to index providers such as S&P, FTSE or MSCI to track their particular index. Fidelity has avoided these fees on their zero-fee funds by creating its own in-house index, The Fidelity US Total Investable Market Index, “a float-adjusted market capitalisation-weighted index designed to reflect the performance of the US equity market, including large-, mid- and small-capitalisation stocks.” The international index tracker will track the Fidelity Global Ex US Index and will use the same methodology for non-US markets.
Costs are also mitigated by lending out shares to other institutional investors for a fee – a practise known as securities lending. Trading strategies that profit from falling share prices, often employed by hedge funds, require borrowing the stock in question. Index fund/ETF providers, with a huge pool of largely inactive holdings, are natural suppliers. This is a common practise whereby a portion of the revenue returns to investors in the form of lower expense ratios and therefore tighter index tracking.
Some small capitalisation ETFs have already experienced what is effectively a negative expense ratio, as the revenue from securities lending has exceeded the fees (small cap stock lending generates higher premiums due to relative scarcity and illiquidity versus large cap stocks). However, despite the perceived benefits of securities lending, it does introduce an element of additional risk, albeit small.
Whilst index mutual funds make up a much smaller segment of the passive investment universe compared to exchange traded funds (ETFs), the news served to highlight the ongoing strain on the profit margins of the large asset management firms, with many of their share prices under pressure following the announcement. BlackRock’s shares fell by around 7% despite most of its business being concentrated in the ETF space via its iShares business.
ETF providers have so far resisted the temptation to cut fees to zero; however, a price war has been ongoing for a number of years. At time of writing, the cheapest ETFs tracking broad market indices had an expense ratio of 0.03%. Research by JP Morgan has highlighted the importance of being the cheapest provider of index tracking products. It concludes that ETFs with expense ratios in the cheapest decile (0.15% or less), attracted three-quarters of net inflows in the US in 2017.
The rise of passive funds and the squeeze on fees in this area have also had a knock-on effect on actively managed funds. According to research by the Investment Company Institute, the average cost of US bond and equity funds has slipped from 0.76% and 0.99% respectively in 2000 to 0.48% and 0.59% in 2017. According to Morningstar, their research concluded that the average expense ratio across US funds fell by 8% from 2016 to 2017, the largest decline since they started tracking the data in 2000.
While there is no doubt that investors are benefitting from these ongoing fee wars, there are some concerns that these developments may change the structure of the markets for the worse. Due to ease of trading and lower transaction costs, these traditionally long-term buy-and-hold strategies are increasingly viewed as vehicles for trading, bringing an associated increase in volatility consequently.
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