Low Fidelity

Jonathan Clements

WE HAVE FINALLY HIT rock-bottom. Last week, Fidelity Investments announced that it was introducing two index funds with zero annual expenses, while also slashing expenses on its other index funds and dropping the required minimum investment on all funds, both actively managed and indexed. All of this raises five key questions.

1. Why is Fidelity doing this? I view Fidelity’s move as both bold and borne of desperation. When I started writing about mutual funds in the late 1980s, Fidelity’s swagger bordered on nauseating, as it relentlessly pedaled a slew of star fund managers, notably Magellan’s Peter Lynch.

But like almost everybody who plays the market-beating game, the odds eventually caught up with the Boston behemoth. Today, its reputation for minting winners is all but forgotten. The upshot: After decades of pooh-poohing index funds, Fidelity has clearly decided they’re its best bet for getting new investor dollars in the door.

2. Is this a bait-and-switch? When Fidelity, iShares and Charles Schwab started slashing expenses on their broad market index funds to compete with Vanguard Group, I initially feared that they were looking to lure unsuspecting investors into their funds and then, once the funds were bloated with assets, they’d jack up the fees. It wouldn’t be the first time this has happened. We’ve seen it before with both money-market funds and S&P 500-index funds.

That’s still a risk, especially if we got a long, brutal bear market that puts pressure on profit margins at fund management companies. But today, I find I’m less concerned. With so many major fund companies engaged in this price war, any company that backtracked on its expense cuts would be tarred and feathered for betraying the trust of fund shareholders—and deservedly so.

Instead, investors need to be leery of a subtler bait-and-switch. Fidelity’s zero- and minimal-cost index funds are open-end mutual funds, not exchange-traded index funds. Why go that route? Fidelity wants folks to open accounts at Fidelity itself, rather than having an account at, say, Schwab and using that to buy a low-cost Fidelity ETF. Fidelity’s hope is to build lifelong relationships with customers, who might start out with index funds that make no money for Fidelity, but end up owning Fidelity’s pricier merchandise. My advice: If you have a fondness for your financial future, stick with the cheap stuff.

3. Is Fidelity’s move significant? It isn’t clear that paying nothing in fund expenses is a whole lot better than paying, say, 0.04%. There are other issues that are also of importance, like skill in replicating the underlying index, which index is tracked, and how much the fund makes from lending out the securities it owns and whether that money is credited to fund shareholders. Earlier this year, I looked at the performance of some major index funds in 2017. Tiny differences in annual expenses didn’t necessarily show up in fund returns.

While Fidelity’s lower expenses may not be significant, I think its scrapping of investment minimums is hugely important. Mutual funds are supposed to be the way for everyday Americans to tap into the financial markets, and yet lately the price of admission has become too steep for my taste. I think it’s great that Fidelity has dropped its investment minimums. Schwab, too, has no required minimum—at least for its index funds—which I also find admirable.

We need to make it easy for folks to get started as investors. Cash-strapped families, who might be deterred by the $1,000-plus minimum required by so many fund companies, now have two great choices.

4. What does all this mean for Vanguard? I have all my investment money at Vanguard. I love that the firm operates its funds at cost and I trust the folks there to act in my best interest. But there’s no doubt that Vanguard is in a bind. Fidelity, iShares and Schwab can only offer super-low-cost index funds because other parts of their business are subsidizing these funds.

Vanguard doesn’t operate that way. It manages each fund at cost. If it were to mimic Fidelity and these other fund companies, it would be forced to subsidize its flagship index funds with its other funds. The fund complex would still be operated at cost, but not each fund—and that would be contrary to what investors expect of Vanguard. The price war among total market index funds is hardly an existential threat to Vanguard, but it does mean the firm may grow a tad slower.

5. Should you move your money to Fidelity? I’m not. In my taxable account at Vanguard, I have funds with large unrealized capital gains and selling would mean big tax bills.

But if I were starting out, I might well favor Fidelity or Schwab over Vanguard, especially if I had a modest sum to invest—and especially if I was investing retirement account money. If either firm jacked up expenses, it would be easy enough to move the money elsewhere, with no taxes owed, thanks to the tax deferral offered by retirement accounts.

As I see it, minimal-cost index funds are sort of like rewards credit cards. If you pay off your balance in full every month, you can collect your cash back and travel points, with those rewards effectively subsidized by folks who foolishly carry a balance. Similarly, Fidelity, Schwab and others are offering the chance to buy low-cost index funds that are effectively subsidized by other investors. If you can resist the temptation to buy the higher-cost merchandise these firms offer, you’ll get your reward—and others will pay the price.

What if everybody opts for the bargain-priced funds? Instead of Vanguard, it would be Fidelity, Schwab and others who would be in a bind. But I don’t think they have much to worry about: An outbreak of rationality doesn’t appear imminent.

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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