ETF Fees: Zero Is Not the Floor - It's the Beginning

Fidelity – First Index Funds At Zero

By Timo Pfeiffer, Solactive

It is a game changer for the entire industry. With its announcement of the first zero-cost index funds in the US, Fidelity has sent shares of major ETF managers south amid investors’ fear for their business model. And I think, it is just the beginning!

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“Our fees will go towards zero – without actually touching it.” said Tim Buckley, Vanguard´s CEO, in a recent interview with German financial daily “Handelsblatt”. I actually agree that there´s a clear race to zero, but have a different view on the actual end stage.

Let me tell you why.

Race to Zero

The cost pressure has been enormous in an industry in which the added value of the fund manager is becoming less and less valued by investors. Active managers feel the strongest pressure as their business model underperforms – measured by the money inflow – against low-cost passive investment funds.

Investors pay an average of 1.4% for an actively managed equity fund whereas passive equity ones cost around 0.6% in fees.(1) Fees that are still significant when displayed in absolute terms.

On a Dollar 10.000 investment, this accumulates to $60 annually. The jump to zero hasn’t come as a surprise, but rather the next intuitive step. The cheapest ETFs or Index Funds already charge less than 0.1%. Currently, over 400 ETFs listed on have an expense ratio lower than 0.2%, and investors are starting to question the pricing policy of many of the higher priced index funds. Surely, not every expensive ETF is a rip-off and fees should never be the sole criteria when choosing an ETF investment.

Many thematic and complex ETFs and their corresponding indices have higher costs due to the underlying intellectual property and value-add. But when we look at simple, market-cap weighted pure beta indices, their rebalancing costs are low, their construction methodologies are extremely simple, and they have been around for almost a century. The corresponding “cheap beta” ETFs and Index Funds are consequently facing most pressure towards zero as seen with Fidelity. They are usually large and also offer the issuer alternative ways of earning money through other means than management fees.

Making Money With Zero Cost Funds

One way to cover the costs of an ETF and allow Fidelity – and others – to operate a zero-cost fund is lending shares to short-sellers.