Fidelity created ripples across the asset management industry when in August it announced two 0 per cent AMC passive funds – one for US equities and one for global ex-US equities.
Last week’s launch of two further, doubling its “zero funds” to four. The two launched in August that have already raised more than £770m in assets under management.
We all understand the pressure on fees, but offering funds for free is a new low in the race to the bottom, and as all Facebook users now know, free to use does not mean that there is no cost.
In financial services we also all understand that nothing comes for free, so how will Fidelity make money, and has it won the race to the bottom?
Over recent years, news of the rapid rise of ETFs and passive investment has never been far from the headlines. Since the turn of the century, passive investment via ETFs has grown at a phenomenal pace with assets held in ETFs and ETPs now standing at almost $5tn (£3.8tn).
Part of the reason for their popularity has been due to the difficulty active managers have had outperforming in a QE driven world.
Another reason has been down to cost. The operating costs of running passive funds is far lower than that of active funds. Without an expensive fund manager to pay, index fund providers can lower their management fees but still generate similar margins. Given the choice of two funds with similar performance but one has lower fees, investors have been a simple choice.
As ETFs and passive funds continue to grow, competition to capture a slice of the pie has been rife. New ETF providers have been springing up on a regular basis, with BMO and JP Morgan being among the more recent. Each has a subtly different range of indices tracked and marketing in order to present a competitive edge.
However, the most effective weapon remains reducing fees. This has not only driven down the cost of passive investment, but forced active managers to follow suit.
In 2000 the asset weighted expense ratio across all US funds was 0.93 per cent and by 2015 has fallen to 0.6 per cent and in active funds from 1 per cent to under 0.75 per cent, according to data from iShares.
The strategy works. Investors have been migrating from high cost funds to cheaper alternatives in their droves.
Once fees reached a level that left providers with very little room to reduce any further, the industry began to believe the race was over. However, innovation is abundant in the passive world and firms worked out it’s deeper to creating create your own indices, avoiding large licensing fees to S&P or MSCI, cut fees and not erode margins. Lyxor’s new ETFs charge an AMC of just 0.04 per cent on a free index.
By creating a stable of funds with a 0 per cent AMC, Fidelity have gone one step further trying to catch-up with iShares and Vanguard. At first glance 0 per cent AMC looks a great offer. However, as with all these things, the devil is in the detail.
Firstly, the funds are only available on Fidelity’s own brokerage platform – the same platform charges almost $50 (£38) a trade to purchase any non-Fidelity funds.
Secondly, the funds will be based on Fidelity’s own version of US and international equity indices to reduce licencing costs as described above. Although the indices have been designed to imitate those which are more well known, the actual performance may slightly differ.
Finally, stock lending. Many asset managers lend their investors’ equities to short sellers, charging a fee in the process. This is not secret, BlackRock, for example, returns 62.5 per cent of this revenue to the funds that lent them, adding 1 to 9bps to annual returns.
For Fidelity’s funds, the beneficiaries of stock lending, who’s at risk and how aggressive the lending practices will be remains unclear. There could be a mismatch between who bears the risk and who benefits.
BlackRock’s lending practices are quite conservative; over-collateralised to 110 per cent and only a small proportion of the fund is on loan at any given time. BlackRock could make more money if it lowered the collateral requirements, accept more risky counterparties or lend more, but this would increase risk to investors.
Fidelity is winning the race to the bottom. Whether it is truly beneficial for investors is uncertain. As all human history has shown, you get nothing for free. Putting cynicism to one side for a moment, if the changes introduced puts pressure on other fund providers to reduce their fees, investors as a whole will benefit as the total cost of investment falls for all, and that’s not a bad thing.
Paul Muir is head of fund research at Tatton Investment Management