Loss Leader

Fidelity Investments has sent a jolt through the investment world with its release of four new mutual funds with zero expense ratios.   That’s right – they’re free!   The Fidelity Zero Total Market Index Fund (FZROX) has no operating expense ratio and no minimum investment requirement either.  This means that anyone with any amount of money can invest for free.    Three other zero-fee index funds are also available covering the U.S. and international stock markets.  

These new zero-fee funds from Fidelity take the pricing wars to a new level.  I’m actually more excited that Fidelity has also simultaneously cut expenses across its entire line-up of index funds, which were already extremely low-cost.   This is just the most recent volley in the index fund wars.  Vanguard started it by pioneering index funds and relentlessly driving down prices as the only significant player in the low-cost, passive marketplace for many years.   This forced other companies to follow suit.  Fidelity leapfrogged them a few years back by launching a number of index funds of their own with even lower expenses.   More recently, Charles Schwab made a lot of noise with a loud promotion of its own index funds, which undercut both Vanguard and Fidelity.  The proliferation of exchange traded funds (ETFs) has also helped to drive down prices.  

Savvy consumers have been able to take advantage of this price war between the big three discount brokerage firms.    In fact, I’m confident that these companies actually may not make any money on my clients and quite probably lose money servicing them.   In addition to incurring the costs to handle the mutual fund investments, they also provide various custodial duties including recordkeeping and tax reporting, for a paltry amount of money.   That said, please don’t feel bad for these companies.   Fidelity is a private company owned by the Johnson family of billionaires, and Charles Schwab shareholders have done quite nicely over the years, including Mr. Schwab himself.   Vanguard’s profits are given back to the investors through lower fees by virtue of its status as a mutual company rather than a traditional profit seeking enterprise.   If they are willing to offer index funds at a loss, I’m all for it.  They will make plenty of money on other products and services.

In fact, I recall the term “loss leader” from my graduate school days to describe how many companies sometimes offer products at a loss in order to bring in customers in order to sell them other products.   The idea is to promote tomato soup priced a few cents below cost and place the cans on the shelf next the pricier Classic Chunky Tomato Bisque!   This marketing battle with index funds is similar although much tastier in my view.   As long as you stick with the low-cost funds, and steer clear of the expensive offerings, it’s a great deal for consumers.   These products cut out the middleman and leave the investor with nearly the entire return provided by the investment.  Their loss is definitely our gain!

The free part is a bit of a marketing gimmick in my view, although I’m not complaining.  Fidelity had already been offering index funds nearly for free.  The previous expense ratio for the Fidelity Total Market Index Fund – Premium Class (FSTVX) was 0.06 of 1%.  This means that on an investment of $100,000, an investor previously paying $60 per year will now pay nothing for the equivalent Fidelity Zero Total Market Index Fund.  With the latest across the board cuts, the more established Fidelity Total Market Index Fund – Premium Class (FSTVX) is 0.015 of 1%, or just $15 per year for a $100,000 investment.    When you are slicing this thin, there’s really not much room for improvement.

Rather than using an established benchmark like the Dow Jones U.S. Total Stock Market Index in order save the license fee payable to the index owner, the new free version will use its own in-house index to replicate the return of the stock market.  Of course, it is also important to note that it will not have a track record.  Since they are passive investments that are not trying to beat the market, this should not be concern in that purchasing index funds from reputable companies doesn’t require the same level of due diligence as other funds.   They are transparent and essentially interchangeable, so low-cost usually wins.  Even so, the manner in which the index fund is constructed and maintained should be considered.  For the small difference in cost, any of the index funds offered by Fidelity, Vanguard and Schwab – and some ETFs – are excellent investments.  

At the same time, how can you not love the value proposition of free investing?  Consider for example a young person who wants to get started with investing – maybe in a Roth IRA.  With no minimum amount required, a young investor can effectively own thousands of publicly traded companies and enjoy all of the gains they produce over time and not incur any costs or taxes whatsoever!   I can’t think of a better way to grow wealth. 

This entire “Loss Leader” saga reminds me of the song lyric chanted by bystanders during the Limbo dance craze, “How low can you go?” and makes we wonder how low will they go?  Can fund expenses go any lower than zero?   I don’t know, but I can’t help but wonder if companies will soon start paying me to invest with them?