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Malcolm Kerr: Why more asset managers should consider no-fee funds

By Malcolm Kerr

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Oct 04, 2018
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Fidelity’s new zero-fee index funds have rocked the boat in the US. Players here must sit up and take notice

I was interested to see that Fidelity has launched two new index funds in the US: Fidelity Zero Total Market and Fidelity Zero International. Both have an expense ratio of zero per cent.

Fidelity was late to the ETF and index fund explosion in the States but it looks like it is using its scale to accelerate growth in this space and win its battle with BlackRock, Charles Schwab and Vanguard.

Scale is important and Fidelity is a huge international player with annual revenues of around $18bn. That is twice the revenues of the entire ETF market and four times the revenues of Vanguard. So, even if this strategy is a loss leader, it can afford to roll with it.

This got me thinking about index funds generally; why they have experienced exponentially increased inflows over the past few years and what might happen next.

Where it all began

The story starts in 1976 with the launch of the Bogle-LeBaron First Index Fund, which only achieved 10 per cent of its $150m target – unsurprising in retrospect, as it carried an 8.5 per cent sales charge. It also encountered tracking challenges resulting from a need to reduce costs and only sampling the smaller stocks in the S&P 500 as opposed to all of them.

Renamed Vanguard Index, merging with another Vanguard fund and tracking the entire S&P 500, the proposition started to gain traction. By 1987, it had reached $500m and other players had joined the market. Technology reduced trading costs, competition brought expense ratios down and tracking errors were almost eliminated.

But penetration in the UK was minimal. The reason was simple: they did not pay commission to advisers. This all changed with the emergence of Transact and others, where fees could be taken from the platform.

And it is no coincidence that, on some platforms, index funds occupied the top spot in terms of flows. Index fund sales growth was then further fuelled by players such as Dimensional, which were evangelists for the proposition and knew how to market it. Finally, RDR and the complete removal of commission bias.

RDR was designed to provide complete transparency of adviser fees and the use of index funds reduced the overall client charge. Some suggest this might have contributed to increased sales. Others say advisers lost confidence in the value that active managers brought to the party. My guess is that it was a combination of both.

Most direct-to-consumer digital platforms now use index funds. That is sensible, particularly if their target market is first-time investors and/or consumers looking to make regular investments. Costs are low and the proposition simple.

The reason I mention regular investors is that a portfolio comprised primarily of index funds is unlikely to be suitable for most clients looking for sustainable income. There must be scope for a divestment index not based on the size of companies’ market capital. There are ETFs based on dividend yield that might have a role to play, for example. But, in the meantime, active management seems a more sensible approach…

What next?

So, where next? If index funds are a commodity, then Fidelity could be on to a winner in terms of shares in this increasingly popular space. But perhaps there is more to it than that. What about brand? What about service? What about stock-lending strategy and governance? Are there trade-offs? I think there might be.

After all, if a US adviser rates a manager highly in these areas, would they want to move client money from Schwab or Vanguard or BlackRock to save a few dollars?

And then there are other issues to consider, such as the cost of the adviser’s time and tax wrapper implications.

More important for us, though, will Fidelity and others export their US pricing strategy to the UK market? If so, how will it impact advisers and fund managers? Seems to me it would be good news for the former and their clients but a challenge for the latter.

There may be a way to mitigate the loss and that might be the 0.02 per cent or so revenues that could be generated by lending stock to short sellers. But are these revenues reinvested to the benefit of the investor? If so, they might amount to more than the annual fees. Or are they retained by the fund manager?

If the revenues are retained by the fund manager, could we see the retail index fund market models turned on their head? If stock lending generates enough revenue for the manager, then perhaps the next step from zero charges might be paying investors to invest rather than charging them.

Before you commit me to the asylum let us think seriously about this. Could it not be a cost-effective way for some players to engage new customers and then, over time, sell them highly profitable propositions such as actively managed drawdown solutions?

Malcolm Kerr is an independent consultant

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