Fidelity's Free Funds
Today’s blog post is going to focus on the news that Fidelity is now offering a couple of index funds that carry no cost to the investor. While providing a free investment seems like an enormous step in fee compression on index funds, it appears to me to simply be the latest in their line of marketing campaigns. I want to take a look at how these new funds compare in terms of price and what that difference in price actually means. I’m also going to dive into whether it makes sense to switch to these new funds if you’re currently investing in an index fund strategy, but let’s start by breaking down these new funds.
New vs Old
The ability to say that this new index fund has an expense ratio of 0 is a great marketing scheme and will certainly turn some heads, but let’s compare that to some of the other large index funds to see how much of a difference that makes. These new funds aim to be a total stock market index which means that they will try to encompass all the publicly traded stocks on the US market, so let’s quickly compare that to other funds which track a similar index. The most well known fund company for index funds is Vanguard, so let’s take a look at their comparable fund. Vanguard total market index has an expense ratio of 0.04% which is run at cost, so the fees you’re paying are just the fees needed to run the fund and nothing extra. There are lesser known funds at Schwab and others at Fidelity that charge slightly less but don’t come with the reputation that Vanguard has earned.
So, while having a free index fund sounds great, by looking at the other major funds available it’s easy to see that the cost difference is actually not that great. Vanguard’s fund is only 4 basis points more expensive and Fidelity’s other funds are barely more expensive. Don’t get me wrong, expenses do play a large part in making sure the investments you choose are right for you, but not so much at the level of a few basis points. When the price difference comes down to less than 10 basis points, there are other factors that are going to be a much higher on the list of concerns than price. Now, this strategy is certainly making a splash as “Free Investments” is likely to turn some heads, but as far as I can tell there’s no new investment strategy involved. It’s still the basic strategy of index funds, buy as much as you can on whichever index you’re tracking and try to keep costs down so that you can partake of the gains of the market. So, let’s think about it as a marketing tool, and not an investment for a second and see where that leads us.
Vanguard runs their mutual funds at cost, which means that an index fund that has no expense ratio is definitely operating at a loss. Also, using common sense it’s easy to see that if a company is giving something away for free, they’re taking a loss on whatever it is they’re giving away and they’re hoping to make that loss up elsehwere. I don’t think it’s a secret that Fidelity and other investment firms are for-profit companies, which means that there has to be a reason they’re ok running a fund lineup at a loss. This leads us to one of a limited number of conclusions: either they will eventually raise the cost of the index funds or they will be making their money on other products and are using these free index funds as a type of bait to get you in the door. This means that there will likely be sales pitches involved at some point in your investment experience if you decide to enter these free index funds, which may or may not phase you, but is something that you should expect going into this situation. Now that we have covered the broader index fund situation, let’s take a look at whether it makes sense to switch into these new funds in order to take advantage of the 0% expense ratio.
Should I Stay or Should I Go?
While free is hard to ignore, I would say that it is worth taking a second before making a decision to switch your investments into these new funds. If you’re just starting out and looking to make your first investment this could be an option to consider as it wouldn’t upset any previous investments and free is still free. Perhaps if your money is already at Fidelity in an index fund strategy then it may also make sense to switch. However, if you have an established index strategy that’s been in place for awhile I would be hesitant to jump ship to these new funds. While free is a great price, selling out of your current funds and buying into these new ones could create a taxable event which would add some drag to your investment returns and cost money in the short term. If you’re currently invested in index funds at Vanguard or another firm, I would preach patience in terms of making a switch as there could be a lot of hassle in transferring accounts and we simply don’t know how these new funds will perform. Now, it’s possible that these new funds will do very well, there won’t be any sales pressure to expand into other products and everyone will be very happy that they switched over, which would be great. However, if that’s the case then you can always switch after that has been established and all it will cost you is a few basis points in the meantime. On the other hand, if that’s not the reality then you’ll be happy you avoided the headache while paying a tiny bit more to do so. So, to sum up, I would wait to see how things unfold with these new funds to determine if it’s worth switching.
Are you intrigued by the new free funds? Are you thinking about investing in these funds, either for the first time or switching from another firm? If you’re interested in learning more about index funds or discussing your specific situation, send me an email and we can talk about how investments can be used to reach your financial goals.