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The first free index funds are finally here!  Tomorrow, Fidelity will unveil two broad-based, self-indexed mutual funds with a 0.00% fee.  In 2016, I made the prediction that several prominent ETFs will lower expense ratios to zero in 2017.  I was off by a year and had the wrong investment vehicle, but hey – close enough.  Quite frankly, the biggest shocker to me is that an ETF didn’t get to zero first, though it’s only a matter of time.

Fidelity is no charity, so the first question you may be asking is how they can offer free index funds.  Three reasons:

1) Because these funds are self-indexed, Fidelity isn’t forking over licensing fees to an index provider.  An index fund is just that, tracking a benchmark of stocks or bonds typically put together by an independent, third-party provider.  That provider, of course, charges a fee.  Bloomberg reported last year that MSCI, one of the largest index providers, charged an average of 3.05 basis points (0.0305%) to ETFs using an MSCI index.  The largest ETF in the world, the SPDR S&P 500 ETF (SPY) currently pays S&P Global 0.03% annually, along with a yearly $600,000 license fee, for the right to track the S&P 500 index.  If you do the math, that works out to over $80 million in costs to SPY each year!  Cut out the index provider and you can reduce the costs of running an index fund – savings which can then be passed along to investors.

2) Securities lending. This is a common practice where fund providers will lend out stocks held in a fund, typically to short sellers who are betting against the stock.  Short sellers must pay a fee in order to borrow stocks and that fee revenue can be used to compensate the fund provider and/or offset fund costs.  Here’s a good, quick primer on securities lending.  That said, Investment News ran the following statement yesterday from Fidelity:

“Fidelity’s securities lending program is designed to benefit fund shareholders. Fidelity is not receiving any revenue from the Fidelity ZERO Index funds for securities lending. Nor is Fidelity currently receiving any portion of the income that is generated from securities lent out.”

Which leads to 3) A loss leader strategy.  Companies deploy this strategy by offering products at a loss with the hope of customers buying other, more profitable products.  In the case of Fidelity, along with several other fund companies offering rock-bottom fund costs, this is ultimately the master plan.  It just so happens Fidelity has the most wherewithal.

You read that right.  Fidelity’s annual revenue is two times greater than that of the entire ETF industry!  Eric also pointed out Fidelity’s Contrafund alone makes more in revenue than every ETF issuer outside of iShares, Vanguard, & State Street (not for long in my opinion; you can read about that here).  So, very simply, Fidelity’s hope is zero fee funds attract investors and some of those investors gravitate towards more profitable funds and services.  It’s no different than department stores offering Black Friday “door buster” specials at a loss, knowing you’re going to buy other things.  Just get people in the store.  Fidelity also makes money from cash sitting in investment accounts and they offer full service financial advice, both lucrative operations.  Fidelity knows once clients are in the door, it can be a hassle to switch firms or change funds (due to taxes and other frictional costs).  Clients likely aren’t going anywhere and Fidelity can continue to cross/up sell.

Putting the loss leader strategy aside, the fund business is simply cutthroatScale is more important than ever and fees matter in scaling.  For fund companies, low fees have become table stakes if you want to attract investors.  Regardless of Fidelity’s or any other fund company’s specific motivations, fund fees have been steadily creeping towards zero.  The Schwab U.S. Broad Market ETF (SCHB) costs 0.03%.  The SPDR Portfolio All World ex-US ETF (SPDW) costs 0.04%.  That’s $3 or $4 for every $10,000 you invest.  There are currently 34 ETFs with an expense ratio of 0.05% or less.  And make no mistake about it, fund fees matter.  Morningstar found that cost is the single biggest predictor of future fund success:

Source:  Morningstar

 

There’s also no question investors have figured this out.  By my calculations using Morningstar data, out of the approximately $3.6 trillion invested in ETFs, nearly 70% is in products with an expense ratio of 0.20% or less.  90%+ is in ETFs with an expense ratio of 0.50% or less.  The Wall Street Journal recently reported that more than 75% of new money invested in ETFs over the past year has gone into funds with an expense ratio of 0.15% or less.  With Fidelity’s announcement of free index funds, I fully expect other fund companies to follow suit and overall costs will continue trending down.

So what’s the overall takeaway for investors?

1) Obviously, nothing is stopping you from taking advantage of “door buster” fund specials and refraining from buying more expensive funds and services. Good behavior is required here, but if you want to take advantage of free or nearly free funds with no strings attached, you can absolutely do so.

2) More importantly, I think the conversation will slowly shift away from fund costs and back towards the importance of fund selection and understanding exactly what you own.  The discussion surrounding fund fees has sucked all the air out of the room, leaving little focus on other costs, exposure, and fit.  Cost is important, but it isn’t everything and its importance diminishes as fund fees approach zero.  Morningstar’s Ben Johnson has simply, yet elegantly, captured this here:

Look, I preach about the importance of fund fees as much as anyone.  I still can’t wait to see who the first ETF provider will be to offer a free ETF (my money is on Schwab).  But, at the end of the day, fund costs are down to the point where incremental savings are insignificant.  Investors have won the fee war.