SINCE 1975, when the first retail investment fund that aimed simply to mimic a stockmarket index was launched by Vanguard, such “passive” funds have squeezed margins and profits right across the
asset-management industry. On August 1st that trend reached its logical endpoint with the launch of two zero-cost tracker funds by Fidelity, a Boston-based firm built on active investing that is the industry’s fourth-largest, with $2.5trn under management. With no minimum investment required and an expense ratio (that is, net cost to investors) of zero, it will further shake up an industry that was already undergoing a major structural shift.
Fidelity’s competitors immediately felt the heat. Shares in BlackRock, the world’s largest asset manager and largest provider of passive exchange-traded funds (ETFs), closed 4.7% down on the day, as shareholders digested the implications for its business model. Those in Invesco, the fourth-largest ETF provider, dropped by 4.2%, and those in State Street (which, though the third-largest ETF provider, also has many business lines besides asset management) by 1.2%.
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Competition had already driven charges on index-tracking mutual funds and ETFs to very low levels. The fee for the index-tracking mutual fund at Vanguard most similar to Fidelity’s new offering is 0.14%, and its ETF version costs just 0.04%. Charles Schwab’s corresponding offerings cost even less: both the mutual fund and ETF cost just 0.03%. There are economies of scale in index investing, since costs do not rise in line with assets under management.
Without skimming any explicit fee from the new funds, Fidelity will have to find other ways to make money, such as by lending shares to short-sellers for a consideration. It may also see the new funds as loss-leaders, hoping that investors will eventually migrate to its other offerings. To make that more attractive it has cut fees for its existing stock and bond index funds by around a third, which will save investors $47m annually, and done away with minimum investments across the board. And it surely hopes it will be able to “upsell” customers more lucrative products, such as financial advice.
That it was Fidelity that went to zero first was something of a surprise. Its reputation was made on the prowess of its stockpickers. The move therefore reveals just how much active management in shares is suffering. Over the past decade, an average of 87% of actively managed American equity funds underperformed their benchmark indices. Average active-management fees in 2017 were 0.57%.
Active-only asset managers have tried to respond to pressure from passive funds by consolidating. Examples include mergers between Janus, an American fund house, and Henderson, an Anglo-Australian firm; and in Britain, between Aberdeen Investments and Standard Life. But it is hard to see a reversal of the shift toward passive management, which, by some estimates, already approaches half of all assets in managed American equity funds. Fidelity’s move is likely to prompt further consolidation among passive-fund providers, too, even though many are already giants. After all, to make a decent income from such activities as lending shares to short-sellers means doing it at scale.
In recent years Fidelity has lost business to rivals who had moved earlier to focus on passive investing and to squeeze costs. It was already shifting its emphasis. In June a net $5.6bn flowed into its passive fund offerings, even as $2.6bn net flowed out of its active strategies. Its new zero-cost funds will surely accelerate this trend.
The price war in asset management was already fierce. Will anyone go to the wall? At the very least, it is hard to imagine that Fidelity’s rivals can hold off from lowering or even scrapping their fees, too. As free current accounts show, once something is provided for nothing, it is very difficult ever to start charging again.
Correction (August 6th 2018): This article has been amended to reflect the fact that Charles Schwab's total market index-tracking mutual fund costs the same as its ETF version: 0.03%, not 0.09%.