Expense Ratios Aren’t Everything

In the 1973 book, “A Random Walk Down Wall Street,” Princeton University Professor Burton Malkiel made the controversial statement that “A blindfolded monkey throwing darts at the newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.” From what I understand, most people didn’t take the statement too seriously, and certainly, over the years the asset management industry continued to grow substantially.

But ever since then a debate emerged around active versus passive funds, and if active managers are really worth the expense ratios they charge.

As evidence has mounted that it is incredibly difficult for active managers to outperform their indices, especially over the long-term, more money flowed into index funds given their low expense ratios.

Recently Fidelity surprised everyone by introducing a new “zero fee” index fund with no minimum investment.

So, lower expense ratios mean better, right?

Is Fidelity’s announcement revolutionary or just a marketing ploy?

In August 2018, Fidelity announced the launch of two new zero-fee, zero-minimum account balance funds. The first two funds were US-based Fidelity ZERO Total Market Index Fund and internationally-focused Fidelity ZERO International Index Fund. In September 2018, it launched two more: Fidelity ZERO Large Cap Index Fund and Fidelity ZERO Extended Market Index Fund. These funds have 0% expense ratio and no minimum investment amount.

Market participants poured more than $1 billion into these funds in just a few weeks. In the fee wars between index funds, it seems like Fidelity may have won. However, even with this swift inflow, Vanguard continues to be the market leader with $5.1 trillion in assets under management (AUM) far outpacing Fidelity’s $2.1 trillion AUM.

It seems to me that Fidelity is making a marketing ploy here. In a crowded index fund market where firms have been trying to gain market share by lowering fees, they are offering a loss leader. They are willing to take a hit on the administrative expenses of running these funds with the expectation that they will make money on other products. This may help them chip away moderately at Vanguard’s market share, but I believe there’s more to an index fund than its expense ratio.

Still, the idea that you could own an index fund with zero fees interested me because perhaps smart investors should take advantage while eschewing Fidelity’s other high-priced products.

How do Fidelity and Vanguard funds compare?

Vanguard also offers index funds that are representative of the asset classes the new Fidelity funds cover: US stocks of all market capitalizations (Total Market Index), international stocks, US large cap stocks and US mid and small-cap stocks (Extended Market Index). However, there are many differences between the two fund shops.

As explained in the intro, the new Fidelity funds have a 0% expense ratios and no account minimums. Vanguard still has expense ratios and minimums; however, these vary depending on which share class you are invested in: Admiral, ETF or Investor Shares. Admiral shares typically have the lowest fees but highest account minimums whereas investor shares typically have the highest fees but the lowest account minimums. Fees and account minimums for ETF shares are in between the two other share classes.

Currently, the new Fidelity funds are only available as index mutual funds. In contrast, the Vanguard funds are available as index mutual funds and ETFs (exchange-traded funds). Some people prefer ETFs to mutual funds, but I’m happy to invest in mutual funds.

What’s really important when choosing an index fund?

Index funds seem to have become the default investment vehicles for people who don’t want to think much about their portfolios. However, even those investors who just want to own the index still have decisions to make: Which asset classes? Which fund families? How to diversify? How often to rebalance? While investing in index funds may seem lower stakes than choosing actively managed funds, given the lower expense ratios, there are still many factors that influence wise investors’ decisions:

Expense ratios

Yes, expense ratios are important. However, the real savings come when you switch from the average actively managed mutual fund to a low-cost index fund not when you switch between two low-cost index funds. On average, actively managed mutual funds have expense ratios that range from 1.3% to 1.5% whereas index funds have expense ratios that are considerably lower at 0% to 0.20%. For example, for a $10,000 portfolio, you would pay $150 in annual expenses for the industry-average mutual fund versus $20 for the index fund, netting you a savings of $130 by switching to the index fund. For the same portfolio, if you switched from the 0.20% fund to the 0% fund, you would only save $20.

Index fund composition

Index funds often don’t hold all of the securities in an index. Instead, they are constructed as a representation of the index, including sampling and optimization. In general, a broader, more comprehensive representation of an index is better for investors who are trying to mimic the performance of the index. A more concentrated portfolio with fewer holdings may not be as representative of the performance of the index. Vanguard’s funds include more securities (i.e. 3,654 vs 2,500 companies) and therefore are more likely to closely resemble the market versus Fidelity’s funds. Granted, the extra 1,154 companies are probably very small, but I’d rather own the whole market if possible.

Tax efficiency

Expense ratios aren’t the only fees that these funds can face. Taxes count as fees if the funds are held in a taxable account. An investor may incur taxes if the fund experiences capital gains during periods of rebalancing. Historically, Vanguard’s funds have been relatively tax efficient. It’s unclear whether the new Fidelity ZERO funds will be as tax efficient as their Vanguard counterparts. The smaller portfolio composition could potentially lead to higher taxable events if index rebalancing results in more capital gains being passed to investors.

Track record

Fund managers love (or are forced by the SEC to love) the disclosure, “past performance is no guarantee of future results,” so I know that a longer track record doesn’t mean one fund is better than the other. However, there is currently no proof that the new Fidelity funds will mimic index performance as promised. Fidelity is a good fund shop and they know what they’re doing. They likely back-tested the fund extensively before launching it. However, I’m still holding off for a little more evidence of how the new funds perform.

Transactions costs

You can buy index funds on various brokerage platforms. There is typically a fee for each transaction, whether you are buying or selling, although this may vary depending on your account size. Some funds have restrictions on where you can buy them, and if you want to invest in multiple fund families, you may have to have multiple brokerage accounts. Currently, the Fidelity ZERO funds can only be purchased directly through Fidelity.

Trust

Both funds seem to take their fiduciary duty seriously and operate with the best interests of their investors front and center. However, I’m partial to Vanguard given the culture that founder Jack Bogle instilled in the firm. The company is owned by its funds, a structure which is thought to better align the interests of the company and its investors. Fidelity is a privately-held company. This is not a bad thing. It just makes transparency around firm-level decisions a little more complicated.

Why am I sticking with Vanguard?

The ZERO funds from Fidelity are certainly an interesting market development. It remains to be seen if other fund families follow suit and if this trend significantly impacts Vanguard’s market share. However, given my current asset allocation, size of portfolio and stage of investing, I’ll be sticking with Vanguard.

The difference in fees alone is not enough to convince me that a switch is worth the hassle. I’m not willing to incur the transactions fees associated with selling one index fund and investing in another. Also, other factors mentioned above such as fund composition, tax efficiency, track history and ownership structure weigh heavily in my investment decision.

I’m also curious about Fidelity’s strategy going forward and where they are looking to boost profitability in order to make up for the losses they are incurring with the ZERO funds. The president of Fidelity’s personal investing business, Kathy Murphy has been quoted saying, “It is not a rebate, it is not temporary, it is not a promotional offer. It is permanent.” I expect there may be higher cost services pushed, along the lines of advice for investors, higher-margin money market accounts or access to their digital investing platform. Again, this is not necessarily a bad thing, if these services truly deliver value to customers (or if you simply avoid purchasing them while taking advantage of the ZERO funds).

Ultimately, it’s not surprising that this day has come. As index fund providers kept lowering fees, it was a race to the bottom and now the no-fee fund is here.

Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He spends 10 minutes a month on Empower keeping track of his money. He’s also maxing out tax-advantaged accounts like 529 Plans to minimize his taxable income.