Fidelity Bets on Zero-Fee Index Funds

(Bloomberg Businessweek) -- Free mutual funds. It sounds fishy—something that might be advertised on a late-night infomercial. But when Fidelity Investments unveiled two index funds without annual expense charges on Aug. 1, it was the real deal. And if you’ve been watching the money management industry closely, it felt almost inevitable. Several index mutual funds and exchange-traded funds from Fidelity and others were already charging less than a dime for every $100 invested. Why not let the last pennies drop?

The fact that Fidelity was the one to go there is more interesting. The Boston money management company built its reputation on the cult of the star money manager, from Gerald Tsai Jr. in the 1960s and Peter Lynch in the ’80s to William Danoff today. But in fact it long ago moved beyond selling just stockpicking expertise. Under longtime Chief Executive Officer Edward “Ned” Johnson III and now his daughter Abigail, Fidelity has focused on being a financial superstore.

If the no-fee funds bring more customers into the store, “they can sell them other products and services,” says Michael Rosen, chief investment officer for Angeles Investment Advisors LLC, which manages money for endowments and foundations. “This isn’t altruism, it makes good business sense.” The funds are aimed squarely at pulling in everyday retail investors, covering two of the basic building blocks of many portfolios. Fidelity Zero Total Market Index Fund provides broad exposure to U.S. stocks, while Fidelity Zero International Index Fund captures non-U.S. markets. The funds are only available to individual investors, according to their prospectuses. And to buy them, investors have to open a Fidelity account.

At Vanguard Group Inc., the company that pioneered indexing and low-cost investing, the reaction was: buyer beware. “I think investors always have to ask themselves when they see an offering like this, ‘What’s the catch?’ ” says Greg Davis, Vanguard’s chief investment officer. If you’re paying nothing upfront, the endgame is likely hustling customers into higher-fee products, he says. Kathleen Murphy, Fidelity’s president of personal investing, says her company had a simple motive for its move. “We are always trying to use our scale to deliver more value to our customers,” she says.

Fidelity’s move made an impression beyond its index competitors. The stock prices of several major money managers, including Franklin Resources Inc. and Legg Mason Inc., tumbled after the news was released, even though they aren’t serious players in the index business. In a note to clients, Morgan Stanley analysts suggested an explanation: “We continue to see these broader fee pressure trends persisting as competition for client assets intensifies,” the analysts wrote.

One thing a big company such as Fidelity can do is build its own indexes. The no-fee funds follow benchmarks created by Fidelity itself, rather than big names such as S&P Global Inc. that charge licensing fees. If there’s an asterisk on the no-fee funds, it’s that their performance might prove to be a little better or worse than similar index funds using different benchmarks. But since the indexes are so broad, such differences are likely to be small.

Murphy oversees a platform with $2 trillion in retail client assets. Customers who use it can buy individual stocks, active or passive mutual funds from Fidelity or its rivals, exchange-traded funds, college savings plans, and various forms of financial advice. Other divisions of Fidelity manage the retirement plans and benefit packages for corporations big and small. As Abby Johnson told the New York Times in a rare interview in May: “The goal has always been to grow the business beyond the success of the active equity funds.”

With good reason. Fidelity’s stockpicking business has been challenged for years as investors desert active managers for low-cost funds that mimic indexes. In 2010, Vanguard passed Fidelity as the largest manager of mutual fund assets. Today, Vanguard oversees twice as much money, about $5 trillion to Fidelity’s $2.5 trillion.

Last year customers pulled $55 billion from Fidelity’s active equity funds, and the outflows are running at the same pace this year, according to data from Morningstar Inc. In her letter in the company’s February annual report, Johnson wrote that stockpickers are under pressure throughout the industry. She’s right, but a number of Fidelity’s competitors, including T. Rowe Price Group Inc. and Capital Group Cos., have done a better job of hanging on to assets. At Fidelity, even some of the top-performing funds, such as Danoff’s $131 billion Fidelity Contrafund, have experienced steady redemptions. Since 1990, when he took over the fund, Danoff has beaten the S&P 500 by an average of 3 percentage points a year.

Despite all this, Fidelity’s broad mix of businesses allowed the privately held company to report an operating income of $5.3 billion in 2017, up 54 percent from a year earlier. “People focus on their woes—the billions of dollars that are bleeding from their active equity funds—but they are still making plenty of money,” says John Bonnanzio, editor of Fidelity Monitor & Insight, a newsletter. Johnson, who became CEO in 2014, has a net worth of $9.4 billion, according to the Bloomberg Billionaires Index.

Fidelity first got into indexing in the 1980s when Ned Johnson was in charge. Since Abby took over, the business has exploded. In three years, Fidelity’s passively managed assets doubled, to $400 billion as of June 30. “One of the better-kept secrets is that Fidelity has long had one of the most competitively priced suites of index funds,” says Ben Johnson, director of global ETF research at Morningstar.

Because of the lower fees, managing passive funds is far less profitable than peddling active ones. But as investors have flocked to them, Fidelity has been willing to battle for market share. Last July it cut fees on index funds and ETFs. In April it simplified the way it charges for advice. In June it dropped fees on its target-date index funds, a popular retirement vehicle. Eric Balchunas, senior ETF analyst for Bloomberg Intelligence, says Fidelity has been more a follower than a leader in the price war. “This is a world they probably wish never happened,” he says. “But give them credit. They are gritting their teeth and jumping in.”

In contrast, Malvern, Pa.-based Vanguard has been in the price-cutting business since it was founded by John Bogle in 1975. Because of its unusual structure—its investors own its funds, which in turn own the company—Vanguard passes on the advantages of its growing scale to customers in the form of lower prices. Investors pay an average of 11¢ for every $100, compared with the industry’s mean of 62¢, according to company data. Asked whether it would consider any of its own zero-fee funds as a retaliatory measure, Vanguard’s Davis demurs. “Do we pay attention to the competitive environment?” he says. “Absolutely. Are we reactive to what one competitor does? Absolutely not.”

Another big player is BlackRock Inc., the purveyor of iShares ETFs—index funds that trade like stocks—and the world’s largest asset manager. Its stock also fell after Fidelity’s announcement. Yet Martin Small, head of U.S. iShares, sees no need for a counterattack. “We have zero plans for zero-fee ETFs,” he says. BlackRock’s $1.8 trillion ETF complex consists of two different businesses: a set of low-fee funds that compete with Fidelity, Vanguard, and Charles Schwab Corp., and a group of more expensive funds popular with institutional traders. The latter, which generate the lion’s share of ETF revenue for BlackRock, aren’t as sensitive to price competition.

Since ETFs such as iShares can be bought and sold through almost any broker including Fidelity, BlackRock doesn’t have the same opportunity to use cheap funds as a way to build a retail relationship. A company that might seem more likely to follow in Fidelity’s footsteps is Schwab, which was born as a low-cost alternative to traditional brokerage firms and has also built a financial supermarket. It too offers index funds and ETFs with razor-thin costs. The company declined to make an executive available for an interview. “Anytime costs go down, investors win,” spokeswoman Alison Wertheim said in a statement.

So it remains to be seen whether zero is one company’s flash in the pan or the new price point other asset managers will be pulled to. Much will depend on how the new funds perform and how much money they’re able to bring in the door. As they say on late-night TV, how much would you pay?

To contact the editor responsible for this story: Pat Regnier at pregnier3@bloomberg.net

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