Zero-Cost Index Funds: Is there a Catch?

09/19/2018 5:00 am EST

Focus: FUNDS

John Bonnanzio

Editor, Fidelity Monitor & Insight

On August 1, Fidelity took direct aim at index fund competitors Vanguard, Blackrock’s iShares and others by launching the nation’s first zero-fee index funds, explains fund expert John Bonnanzio, editor of Fidelity Monitor & Insight.

They also put “discount” competitors like Schwab on notice that they’re intent on regaining market share in both the investment and brokerage arenas by slashing many other fees to zero. Moreover, they’ve eliminated fund minimums to attract new and younger investors.

While Fidelity says its moves will save shareholders about $47 million a year, that’s a mere rounding error for a firm which, in 2017, had $18.2 billion in revenue. Still, Fidelity has clearly turned up the heat industry-wide. Below, we peer under the hoods of these two new funds.

Zero Total Market Index (FZROX) and Zero International Index (FZILX) are “self indexed” funds. That is, they use proprietary benchmarks created by Fidelity. Their affiliate, Geode Capital, is the subadvisor, just as Geode is to dozens of other Fidelity index offerings including their Enhanced Index funds, Factor ETFs and certain Central Funds.

Significantly, Fidelity’s management company, FMR (not the funds’ shareholders), pay Geode 0.0125% and 0.0525% to subadvise their Zero Total Market and Zero Int’l index funds, respectively.

In using Fidelity’s own indexes, Zero funds avoid having to pay Dow Jones and MSCI for the right to use their benchmarks, which the (non Zero, or “regular”) Total Market Index and International Index funds have to do. That partly explains why those particular index funds have expenses of 0.015%.

While their expenses are minuscule, we expect Fidelity to eventually ask those funds’ shareholders to merge their assets into their new zero-expense cousins. That said, there are some differences beyond expenses that, over time, may result in the funds’ long-term returns — and perhaps their volatilities — to ever-soslightly diverge.

For starters, Zero Total Market has “only” 2,500 holdings versus 3,400 for Total Market. It uses a statistical sampling of the broader market rather than hold each and every public U.S. stock. (This helps to reduce trading costs.)

On the margin, it also creates some differences in market cap, though both have about 80% of assets in mega– and large-cap stocks. Second, the Zero funds’ respective sector exposures (and in the case of Zero Int’l, country weights) will likely be quite similar to their “regular” counterparts, though not identical.

Sector-wise tech will account for about a quarter of Zero Total’s assets followed by financials and health care at roughly 14% apiece. (That’s close to Large Cap Core Enhanced Index, a semi-actively run fund with higher expenses of 0.40%.) Consumer discretionary is about 13%.

As for Zero Int’l fund, again, mega- and large-cap stocks dominate, though without giant U.S. stocks, we expect its market cap to be much lower than Zero Total Market. In addition, the Europe dominated fund will have a high single-digit weight in tech, whereas financials (namely banks) will be the largest segment.

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