Fee-free trackers have landed – and that’s a good thing

The most basic selling point for “passive” investing and exchange-traded funds (ETFs) in general is that they are a lot cheaper than traditional funds. It’s taken a while, but investors the world over have now cottoned on to one simple fact: of all the important variables that can affect your investments over time, you only have complete control over one of them – your cost of investing. So a sensible investment process starts with getting that cost as low as possible.

More than anything else, it’s this widespread recognition that costs matter, that has driven the passive revolution. It’s true, as Morningstar points out, that more than 80% of the money in US investment funds is still sitting in mutual funds (that’s Oeics or unit trusts in British money), while 19% is in ETFs. But that’s pretty impressive given that ETFs started from around 0% in 2000. Indeed, the volume of assets in ETFs has grown by around 16.5% a year over the past decade, compared to just 2% for mutual funds.

And if you look at the money flowing into funds – both mutual funds and ETFs – over time, notes Morningstar, you find that increasingly, it’s been all about the fees. Since 2014, the least expensive fifth of funds have attracted all of the net inflows of new money. The rest of the fund universe has lost money. And this pace is only picking up.

So the reality for the financial industry is pretty clear: if you don’t launch cheap funds, you won’t get any traction.

The only question now is – how low can fees go? And that’s where Boston-based investment giant Fidelity comes in. The fund group has just broken new ground in these price wars. Not only has it cut the cost of all of its index-tracking funds, but it has also introduced two new tracker funds – covering US large caps and International stocks – that have a 0% expense ratio.

In other words, ‘cheap’ now means ‘free’.

That’s extraordinary. Sure, it’s fair to say that, if you are already in the cheapest tracker funds and ETFs, then you are already paying so little (0.2% or well below in some cases), that getting market exposure for free won’t represent that much of an investment gain. But for those who still haven’t quite caught up with the sheer scale of price drops in recent years, this is great news.

Fidelity – which has a vast stable of very popular active funds – can afford to dip its toe in the water here. As the FT points out, the company made a record $5.3bn operating profit last year – this decision is costing it less than $50m.

You can certainly argue that Fidelity is pushing a loss leader to the savviest investors, while generating a lot of attention for itself and potentially its active funds. And there are other ways for index funds to make money – by lending securities out for shorting, for example.

So far other fund groups – including ETF giant BlackRock – have argued that they won’t follow suit. But the direction of travel is clear.

A fair deal

So what’s the upshot for investors and the industry as a whole? First, I want to make it clear that this is a good thing. The financial industry has been shielded from competition by a lack of transparency on costs (and a somewhat questionable semblance of expertise) for far too long. This is now well and truly over and consumers are finally getting a fairer deal.

We’re moving towards a future in which there will be fewer active managers, running smaller amounts of money. But those who do remain in the industry will be good at their jobs and thus be able to command higher fees, although probably within a fairer structure.

Meanwhile, passive fund managers and ETF providers will find ever more elaborate ways to parcel up smart beta products, thematic ETFs, and the like in order to justify charging more where possible. ETFs meanwhile will be judged more on measures such as tracking error and liquidity.

None of this means that there won’t still be bad products and poor value funds out there. But investors with a reasonable grasp of the industry should find it easier to locate cheap, high-quality products that allow them to implement whatever strategies they have in mind.

The other point I’d make, is more of a market-timing, philosophical one. Costs have become the key focus of investors, and that’s a good thing. For too long, they were ignored. However, you can get too much of even a good thing, and I do wonder if this ‘free’ fund launch suggests that we might be near something of a high-water mark when it comes to a relentless focus on costs.

Whenever the next crash comes, there’s no doubt that passive flows and ETFs will take some of the flak (justifiably or otherwise) and that could encourage a bit of a swing back towards active managers (who will be sold to investors as being defensive in bear markets, even although all evidence suggests they aren’t particularly good at this either).

With markets currently looking expensive (especially in the US), I’m always on the lookout for signs of a top. It wouldn’t surprise me if this fee-free fund is an indicator of the sort of exuberance that usually precedes such a setback.

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