The average fee charged for passive index funds has been falling for years; pundits and commentators have even suggested that, one day, we will see the 0% fee mutual fund or ETF—a fund that gives you exposure to a set of stocks without charging any fees whatsoever.
That day has arrived.
Fidelity, which manages over $2.5 trillion across many products, has released two new 0% expense ratio mutual funds: FZROX (for U.S. equity exposure) and FZLIX (for global exposure). Both are total stock funds that provide massive exposure with zero stock picking or value investing principals; the idea in investing in these funds is that, as the market broadly rises, so too will investors’ portfolios.
And, again so the idea goes, because there are no fees, the returns will be higher.
Granted, the cheapest index funds charge less than a handful of basis points, so the actual higher returns will amount to maybe a few hundred dollars over a lifetime for most investors. It’s really a small amount of money—but the precedent has been set, leading some to wonder if, one day, there will be a negative fee fund—that is, a fund that pays investors to let them manage their money, instead of vice versa.
Active fund managers have a right to be worried, especially in the low-performing mutual fund world where index funds have been taking capital for years. But the more interesting question beyond the age-old passive versus active debate is exactly how the economics behind the fund work.
Traditionally, a fund manager will charge an expense ratio to manage assets. Let’s say 0.5%. If the fund gets $1 billion in assets, the fund’s management gets an annual revenue of $5 million—a rather small amount of money, all told ($5 million annual revenue is considered a small business in America). That $5 million must pay for legal compliance, office space, marketing, fund managers, administrators, and research. In other words, just because a fund seems rather large doesn’t mean that the managers are well paid.
Lower funds also make the smaller fund impossible to run. There just isn’t enough revenue to keep the operation going. This is why smaller fund managers have been acquired by larger companies over the last few years—and that trend is likely to continue.
And with Fidelity, they are so large now that they can afford to offer a loss-leading fund like FZROX or FZLIX, because (so the marketing theory goes) it will attract new capital and new customers. Those customers will want to diversify into other products, or maybe take out a loan, or use any of Fidelity’s many other financial products. It’s a customer acquisition cost that, hopefully, will result in higher revenues in the end.
Will it work? No one knows. But the ball is now in Vanguard’s, Schwab’s, and BlackRock’s court. Will zero-fee index funds become an incentive product for big firms, and will it cause smaller firms to struggle attracting capital? Only time will tell.