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When Must a Fiduciary Say “No” to No-Fee Funds?

When Must a Fiduciary Say “No” to No-Fee Funds?
October 02
02:50 2018

Fidelity recently debuted two “no fee” mutual funds – a domestic and an international index fund. This concept raises significant fiduciary questions. Beyond the fact they have no investment performance history, the very concept of the business model has no history. No mutual fund has ever been offered that has been fully subsidized by the management company.

These funds appear to be exactly what they’re telling you. “From my understanding they have zero expense ratios, no expenses for marketing, and when you buy directly from the issuer no transaction fees,” says Billal Adam, Sr. Vice President, Financial Advisor at International Assets Advisory Wealth Management in Fort Lauderdale, Florida.

Do these funds merely represent the end result of the “race to zero,” as some claim, or are they really not much different than what we already have. “Fidelity recently announced index funds with 0% expense ratios, which makes them essentially expense-free,” says Jeffery V. Wright, Managing Director at NovaPoint Capital LLC in Atlanta, Georgia. “This is an interesting headline, however many of the largest index funds have expense ratios that are close to 0%, so Fidelity’s latest move is merely incremental and relatively unimpactful from a practical perspective. It is really a marketing campaign to attract assets to their investment platform, where they assume to collect on fees for other services. Fidelity is subsidizing the relatively low cost of administering these funds with the increase in revenues from the assets they expected to gather as a result of providing these funds.”

Unlike other “low fee” funds, the Fidelity funds do not seem to merely be waiving fees. Elizabeth Kelly, SVP of Operations at United Income in Washington, D.C. says, “These funds are being labeled ‘no-fee’ because they have no management fee and no transaction fee. They also have no minimum investment. This isn’t a fee waiver or explicitly temporary rate, though any fund can increase its expense ratio at any time if it chooses to. In addition, Fidelity has been clear they intend to cross-sell these customers with other (likely more expensive) products and services.”

At issue, then, is whether these new funds, and the business model they’re created under, can remain sustainable over the long-term. “Fidelity’s no fee funds are sustainable,” says Wright, “in that they can expect to make up for lost revenue on the fund from additional revenue from additional assets on their custodial platform which generates revenues from fees or other services. Index funds are commoditized and very inexpensive, often less than 10 basis points, so the business model is not significantly less sustainable than it was, given the volume of assets that Fidelity has custody of.”

These funds therefore have been positioned as loss leaders within the universe of the entire Fidelity portfolio of funds. “Fidelity’s CEO was quoted in Bloomberg saying that the goal of these funds is to get more people to try Fidelity in the hopes of being able to then do other business with them,” says Adam. “Basically this is a way to get people in the door with a loss-leader in the hopes of converting the clients to more profitable products down the road.”

Besides, Fidelity itself might be “too big to make them fail,” to twist a phrase. “Making your clients aware of the risks involved in an investment is paramount for any fiduciary,” says Kelly. “However, to say that these funds are risky because their sustainability hasn’t been proven is a bit of a stretch. Passive index funds are cheap to run and their costs don’t increase much with scale (most of the work is automated), so it’s unlikely that Fidelity is losing much on these products. Further, with $1.5 trillion in fund AUM, Fidelity has the financial stability to maintain loss-leaders, and likely did their homework to make sure they’re worth it long-term. As long as they’re popular enough to achieve Fidelity’s goal of attracting new customers (and they seem to be), it’s likely that Fidelity will keep these funds around going forward.

The primary fiduciary risk, besides the “bait-and-switch” usually implied when featuring loss-leader products, is the same problem that occurs whenever anyone chases a single factor, whether it be low fees or high performance. “The risks to the investor are not understanding the investment risks of those funds,” says Wright, “and investing in them simply because of the zero-expense ratio, without consideration of other factors.”

A subtler risk involves Fidelity’s stated intention of how it will cut costs normally associated with index funds. “One of the ways Fidelity is able to offer a zero-fee fund is by creating its own indexes to track and not licensing a well-known index like the S&P 500,” says Adam. “So investors need to be aware of what exactly the fund is trying to accomplish vs what index they are assuming its following. They may end up taking on more risk in an attempt to avoid a fee that could be as low as 3 basis points, as a fiduciary we have to be sure to properly educate clients on the risks and all factors when it comes to investment selection, not just the fee.”

Some will undoubtedly ignore these potential fiduciary risks because they are most comfortable with low fees. “Providing funds that have no fees bring to the frugal, small business saver a new way to save with little to no cost,” says Andrew Meadows, Senior Vice President at Ubiquity Retirement + Savings in San Francisco, California. “If there’s a more cost-effective way for small businesses and their employees to save at work it’s a big win for our entire industry.”

Kelly isn’t concerned with the “bait-and-switch” scenario. “These zero-fee funds are the culmination of a long-term market trend toward lower fund fees, not a one-off marketing stunt,” she says. “Evidence of this trend can be seen in Morningstar data, which shows the average asset-weighted fund fee falling from ~.95% in 2000 to .52% in 2017. Fees at the largest fund managers, such as Vanguard and Schwab, have already reached as low as 3-4 basis points, and have been at this level for several years. In the case of Fidelity’s no-fee fund, the company itself has stated that its goal is to attract customers, not make money on the fund itself. While it’s impossible to predict the future, all indicators point away from this being a bait-and-switch.

Still, others prefer to remain cautious, especially given the novelty of the idea and the fact it remains untested. “It’s difficult to be positive or negative on the funds this early on,” says Adam. “Our major concern is the lack of performance data, many funds and ‘custom’ indexes can have tracking errors that only become apparent after a few years; and any money saved from the lower (or in this case no fee) would have been more than made up with even just slightly better performance from a similar proven low-cost option.”

Wright agrees. He says, “Pursuing the lowest cost index fund to save a few basis points while incurring other risks or higher costs is quintessentially ‘penny wise and dollar foolish.’”

But he expands on his misgivings by taking a more comprehensive look at how these funds might fit within one’s entire financial picture. “Another consideration should be the economic cost of buying a fund, particularly if the investor sells current investments to buy the Fund,” says Wright. “With financial markets near all-time highs as they are now, a taxable investor could realize capital gains and incur tax costs that are significantly higher than the potential savings of a few basis points of moving to a slightly less expensive Fund. This is self-defeating and is missing the proverbial forest for the trees, as they say.”

Will these basis points make that much of a difference in the grand scheme of things? Maybe not to the investor, but if “free” becomes an irresistible clarion, Fidelity may find itself to be the big winner in this gambit.

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary Solutions,  Hey! What’s My Number? How to Improve the Odds You Will Retire in ComfortFrom Cradle to Retirement: The Child IRA, and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on TwitterFacebook, and LinkedIn.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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