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War! What’s it good for? How about reducing fees to nothing?

Yes, fund giant Fidelity is now offering North American investors a US total market equity index tracking fund and an international equity tracker fund with fees of 0%.

While many still complain the markets are rigged and that small investors get a rotten deal, Americans who do their research can now invest for free.

So is this it? Investing nirvana?

Not quite.

Firstly these funds are for US consumers – and British investors still seem to pay higher fund fees than US investors in general. That said, even we can get cheap index trackers costing 0.1% or less a year.

Cost-wise, going from there to zero isn’t as big a leap as ditching an expensive active fund charging 1% or more. The big wins have already been achieved.

More subtly, as my co-blogger The Accumulator likes to say even cheapskate passive investors know someone has to be paid somewhere. So what’s the catch?

I see two potential wrinkles.

Firstly, the new 0% funds track Fidelity’s own in-house indices, rather than indices from one of the benchmark behemoths. This will save them paying licensing fees to the likes of MSCI or FTSE, but many investors would prefer index homogeneity across the tracker fund universe.

Second, the 0% funds will probably lend shares to short-sellers for a fee, which Fidelity will pocket. Some feel this practice sees a fund’s investors taking the risk but the manager getting the reward.

Neither wrinkle would stop me investing.

All indices are constructs and I expect a company of Fidelity’s standing has put together something reasonable. (We’ll look into this in the future).

As for the stock lending, defaults on security loans in such circumstances are rare, and should be covered by collateral. The Accumulator has previously expressed concerns though, and it’s true stock lending does add counter-party and related collateral risk to what ‘should’ be a simple fund.

You’ll pay (or not!) your money and take your choice.

Heroes and zeros

One thing not to worry about is Fidelity’s bottom line. The firm achieves roughly $18bn in annual revenues. Most of that comes from managing retirement accounts, active funds, and share trading, not from trackers.

When we last did a roundup, the cheapest world equity index fund for UK retail investors was already from Fidelity, charging just 0.13%. But apparently they offer US investors an equivalent charging just a tenth of that!

Going from such low fees to zero won’t upset Fidelity’s business model anytime soon. Rather, the zero percent funds are a loss leader, like our free current bank accounts. The firm will aim to make the money up elsewhere.

It will also cause headaches for rivals such as Vanguard and Blackrock. These index fund giants are less able to go to zero without scything their revenues.

The future of active management

Eventually I think we’ll see an index fund that charges a negative fee.

That’s right – you’ll be paid to invest!

A fund would achieve this by passing on those stock lending fees to its investors. It’ll probably be a gimmick rather than mainstream, but what a powerful signal it would send.

Sometimes I have to pinch myself. I’m not that old, yet even I can remember when the standard way to invest was to pay an advisor a trail commission of say 0.5% a year forever for putting you into an active fund that charged 2% a year. As if that wasn’t enough, you also paid 3-5% as a one-off upfront fee for the privilege.

There are protection rackets with better terms than that.

No wonder we’ve seen a huge shift to passive investing. Active investing is a zero-sum game, so pound for pound, by charging higher fees the average active fund can only lose by comparison. Simple mathematics guarantees that while there may be a few market beaters, the majority will under-perform – just as the evidence confirms.

For the average edge-less investor (that is, nearly everyone) index funds offer the cheapest, simplest, and most likely path to investing wealth.

Of course, as more people understand this, the financial services industry tries to obfuscate the truth to protect its cash cows.

We’ve all read the articles that misunderstand how passive investing works and blame it on every market evil under the sun – from flash crashes to low returns to high volatility to job losses to, well, giving a toehold for Marxism on Wall Street.

More constructively, some have advanced theories as to how active funds can turn back the indexing hoards.

But these generally fail a quick inspection:

  • Some say active funds must work harder to earn their higher fees. But active investing is a zero sum game. Tens of thousands of smart people are already busting their guts. Everyone works harder, pays more, and on a market wide level the under-performance will persist.
  • Active investing should be the preserve of specialist hedge funds, say others. They overlook the fact that hedge funds as a group have delivered worse returns than a cheap 60/40 passive portfolio for more than a decade. And with over $3 trillion under management they’re no longer niche.
  • Just wait for a crash! Then active funds will prove themselves over dumb index funds that will follow the market down! This overlooks the fact that active funds are the market. (Did someone say zero sum game?) Falling markets are caused by active funds selling shares, or at least being prepared to pay less for them. Where active funds do better in falling markets it’s typically because they always hold a wodge of cash ready for client withdrawals, not because of skill. Cash keeps its value. You can mimic this brilliant strategy by keeping some money in a High Street savings account, and save on the fund fees.
  • A few optimistic people say the industry as a whole should pay for the price discovery service that active managers perform, which index trackers exploit for free. As long as active managers are the ones driving around in sports cars there’s zero chance of that happening.
  • Some say active investing needs to be reinvented through simple Factor Investing / Smart Beta / Return Premium funds. These enable investors to buy into something supposedly more concrete than ‘magical’ manager skill. A retort is that factors may not persist – our own contributor Lars Kroijer is one skeptic.

That last is already happening, anyway, through the proliferation of factor-based ETFs. Their undeniable advantage versus traditional active funds (though not the cheapest market-weighted trackers) is they’re less expensive to run.

Computers don’t demand sports cars!

Active funds must cut costs to compete with zero

I believe that cost cutting is the only way that active funds can compete long-term.

The reason active funds do so poorly as a category is that in a zero-sum game, their high fees gnaw away at their returns.

Before costs are taken into account, there is a share of money in active funds that does beat the market – which is balanced by an equal weight that loses.

The net result is the market return (which is captured most cheaply and consistently by passive funds).

If active fund managers leveraged technology to cut costs across their businesses, they might be able to reduce their total expense ratios to best-in-breed pricing of say 0.3% or less.

That would still be two to three times as expensive as a decent equivalent index fund (let alone a free one) but at least it’d be competitive.

Many people seem to believe they deserve to beat the market. And they like humans managing their money more than machines. Passive investing feels wrong. That’s why the active industry persists.

If active funds were much cheaper, these notions wouldn’t be so consequential, and the case for choosing a tracker over a ‘fun’ flutter on a flavour-of-the-month manager would be weakened.

I don’t say that it would be logical for the average investor to then choose active – they’d still on average lose to the market. But it’d be much less potentially damaging.

Slashing costs – that’s the only proper way for active to compete long-term.

Actively foolish

The industry though continues to prefer an alternative route of spreading fear and confusion to try to salt the earth for passive funds.

Just last week saw another doozy in the Financial Times.

The article – Passive Investing Is Story Up Trouble1 – took a machine gun to modern markets. Albeit a machine gun filled loaded ping pong balls.

The result was a lot of random seeming attacks bouncing everywhere and missing their target.

The piece attacks robot traders for their supposedly indiscriminate – or at least business-agnostic buying – before strangely conflating their activities with passive investing.

Investors in index funds and ETFs are also lamentably clueless, the author implies, pushing up the most popular stocks with their relentless buying.

Never mind that many a robot’s algorithmic strategy is focused on company fundamentals, via the factor investing I mentioned above.

And never mind that – for the gazillionth time – money that flows into the big market-cap weighted funds does not in itself distort prices. That’s not how it works!

Market cap weighted index funds follow the prices set by active investors.2

Anyway, even the allegedly witless robot traders who follow price signals are not just waving their steely fingers in their air. Prices contain information, whether it’s a shortage of cocoa that pushes up the price of chocolate bars or a surplus of some high-flying tech stock that people want to dump after a terrible trading update. A robot trader’s algorithm is not ‘think of a number between one and a hundred and pay it’.

But perhaps the biggest laugh is the implication that passive investing and automated trading has brought imminent ruin to a previously calm money-making oasis.

Stock markets boomed and blew up for a hundred years fine without index funds or robot traders. Flash crashes are dramatic and unsettling, but they last a couple of hours – manias and funks driven by human emotions can persist for decades.

If the big gains we’ve seen for US tech giants like Apple, Alphabet, and Amazon are priming the stock markets for an imminent rout (and I don’t think they are, incidentally) then it will be because active investors set too high a price for those shares – not because passive money dispassionately followed it.

And when the dust settles after the next crash – and there will be a next crash – we’ll see how well these active gurus sidestepped the alleged silliness they see today.

Perhaps a bevvy of skeptical active funds will smash the market and vindicate their high fees?

I wouldn’t hold your breath.

  1. [Search result]
  2. The one quirk is when a company enters or leaves an index that is being tracked, there can be a price impact from passive fund trading and those who anticipate it. But that is a one-time event, is rarely what’s being attacked, and the overall affect is relatively small.

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