The implicatons of the index funds price war

Fidelity recently announced that it is making the fee reduction on its index funds permanent. Fidelity's index funds now have permanent expense ratios of 0.10%, lower than Vanguard's fees in most cases. E*Trade also cut fees on its index funds a while ago, and claims that it is now the lowest-cost provider of index funds. What are the implications of this price war? Some suggestions:

1. Life gets tougher for stock pickers - and that includes hedge fund managers. With the cost of indexing in free fall, active management becomes harder and harder to justify. Don't get me wrong: I'm not saying that a long only, "buy and hold" strategy wins against hedging particularly in a world of low projected returns. Index funds (particularly ETFs) can be used for long-short hedged strategies, and you can do interesting things with asset allocation and rebalancing using index funds. Rather, the relative cost of individual stock selection versus trading entire asset classes is rising.

2. The screw tightens on actively managed mutual funds. Once Fidelity itself starts to tout ultra-low cost index fund, you know the battle to index has been won. I think Fidelity is effectively conceding that there's no justification for anyone to own the Magellan Fund as opposed to an S&P 500 fund.

3. ETFs face a less certain future. Barclay's iShares (ETFs) was the third fastest growing fund group in 2004. But Fidelity and E*Trade index mutual funds are now cheaper than many comparable iShares. Where does that leave ETFs? My gut feeling is that the online brokerages are strongly incentivized to push ETFs (they get the trading commissions), and hedge funds will always use ETFs because you can't short index mutual funds. But competition for retail investor money has certainly increased.

4. Vanguard in trouble? If index funds are used long-term as loss leaders by firms like Fidelity and E*Trade, where does that leave Vanguard? Vanguard can't match E*Trade's and Fido's fees because it would lose too much money.

5. The winners are retail investors. Retail investors are increasingly understanding the logic of indexing. The availability of index funds is growing, with more ETFs and new fund families from firms like E*Trade. And the price of indexing is falling.

Retail investors need to be sure of one thing: that they use investment platforms and instruments that face maximum competition. That way costs will fall and performance will improve over time. It doesn't matter if Vanguard funds are better managed than Fido's today; what matters is that competitive pressure will continue to drive fees downwards and management quality upwards. Even wealthy investors should embrace this approach: dump Merrill, sign up for Ameritrade's managed ETF account. Ameritrade and iShares face a lot more price competiton than Merril (have you seen what's happening to online trading commissions?), so over time they'll become more efficient and deliver better value to investors.

Somehow coverage of the index fund price war until now has missed the wood for the trees by focusing on the narrow question of which index fund is the best value. Big things are happening in the index fund market. In contrast, "Vanguard's index fund still marginally outperforms Fido's after fees" just doesn't seem very consequential.

Your comments are appreciated.

IMPORTANT UPDATE: All future articles about ETFs will now be on ETF Investor. I'm also copying all the back articles from Seeking Alpha to that site, so you'll be able to view all the ETF articles in one place.

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