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!
Distributed ledger technologies such as Blockchain have the potential to disrupt the settlement market and new peer-to-peer trading platforms such as Robinhood are competing with traditional exchanges. At the same time, websites like Yahoo Finance are democratizing access to financial data.
“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 etfsearch.com 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.
Many funds have specific rules on how many of the shares can be lent to short-sellers with numbers ranging somewhere between 20% to 50% of their total assets. Secondly, a zero-cost ETF or Index Fund can also serve as a facilitator for selling more complicated products on the issuer´s shelf. And a large ETF as such can provide a certain value through its market insights, money flows and data points associated with it.
Lowering Costs
From my perspective, the pressure on ETF issuers to lower their existing costs will continue. And index providers are part of that game. In a world where some major index providers still operate with margins north of 70% and charge basis points in fees for plain market cap weighted indices, it won’t come as a surprise that also the indexing world is facing major disruptions. Automation is driving costs down, and is opening doors for disruptive, flat-fee models and different service levels – just ask your cab driver about UBER.
Monetizing Reputation
Looking at major expenses of ETFs, we can see where they are heading. Starting with listings, they are nowadays often offered free of charge or actually even being paid for by the exchanges. I already mentioned above the disruptive potential of Blockchain technology on custody and think it is fair to say that this will also drive expenses down further. That leaves us with index fees: traditional index providers will often tell you that their index adds value to an ETF, while I believe, it´s actually the opposite. Especially for pure beta, market cap weighted indices, an index provider can gain a lot of exposure and reputation through a giant ETF tracking such indices. Should the index provider pay a premium in such cases? Yes, I am sure such a “negative fees” scenario is not far away any more. So, dear SPY out there, are you listening?!
Consequently, will the race to zero really end at zero? I don’t think so.
This article was written and republished with permission from Timo Pfeiffer, Head of Research & Business Development at Solactive.
About Solactive
Solactive AG is an innovative index provider that focuses on the development, calculation and distribution of tailor-made indices across all asset classes. As at January 2018, Solactive AG served approximately 400 clients in Europe, America and Asia, with approximately USD 200 billion invested in products linked to indices calculated by the company globally, primarily via 350 exchange-traded funds from a number of well-known providers. Solactive AG was established in 2007 and is headquartered in Frankfurt.
Disclaimer
The information in this document does not constitute tax, legal or investment advice and is not intended as a recommendation for buying or selling securities. Solactive AG and all other companies mentioned in this document are not responsible for the consequences of reliance upon any opinion or statement contained herein or for any omission. Solactive AG, Guiollettstr. 54, 60325 Frankfurt am Main, Germany. Registered Office: Frankfurt am Main, Registration Court: Amtsgericht Frankfurt am Main, HRB: 79986, USt-IdNr.: DE 255 598 976. Management Board: Steffen Scheuble, Christian Grabbe, Dirk Urmoneit and Christian Vollmuth, Head of Supervisory Board: Dr Felix Mühlhäuser.