Better Than Cheap?

Long ago, when I played on my class soccer team, I had a lucky break. During a game in which we were losing 0-4, I accidentally found myself in scoring zone and, just as accidentally, I hit a diagonal head-shot into the upper right corner of the goal. I went wild, even for my age, and to this day I recall how invigorating it felt. A free pass to glory.

At the beginning of August, Fidelity launched two new index funds with zero (0) charges and no minimum investment requirement. These products are available to US retail clients and accessible through Fidelity’s brokerage platform. As you know I am a fan of low-cost investing; but $0 fees? Where is the catch for the investor? Is this another free pass to glory?

Most services have advantages and disadvantages, but when something is offered for nothing it has more value than what may be the case. By “purchasing” something for free there is no apparent downside. However, common sense tells us from deep down that this cannot be the case. Let’s have a closer look.

Large retail asset managers such as Vanguard, BlackRock, Fidelity and Charles Schwab are in strong competition among themselves and will continue to undercut each other’s charges in an attempt to attract new clients. Aside from increasing the pressure on active managers to reduce their costs, lower fees for passive products are good for investors because, as they say, costs are a fact but performance is a hope. But how can the provider of a passive investment product make any money by charging nothing? They are not in business for charitable purposes.

One source of revenues to the provider is securities lending, which can be quite profitable when done on a large scale. While this does not sound like a risky activity for the investor, the important aspect is what the investment manager does with the collateral received – if kept in kind or reinvested in other assets. In the latter case, you can see more clearly that “no fees” is not equal to “free”: there is more risk.

The other important revenue source is the potential money flows into other products and services of the provider. This is akin to using zero-fees passive products as loss-leaders, the classic supermarket strategy to get you in the store with one product in mind and get you out with a depleted wallet.

If a service or a product is nominally free of charge, the customer himself becomes the product. Just ask Facebook or LinkedIn or any social network: by opening an account with any of them and consenting to their terms and conditions, you become part of their networks and hence part of their very profitable data collection and selling business.

But, you may ask, is any of this – and, in particular, the Fidely offering – such a bad thing? Not necessarily; just don’t base your decision exclusively on price.

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