Fidelity shoots everyone, including itself

by: David Jackson

By further lowering the cost of index funds, Fidelity just shot Vanguard in the head, Barclays in the neck, E*Trade in the leg, and itself in the foot.

Fidelity cut the fees on five index funds to 0.10%. The funds track the S&P 500, the Wilshire 4500 (small and mid-caps), the EAFE index (non-US, developed-market large caps), and the total US market. Fidelity can now claim it's the low-cost index fund leader.

Bad news for Vanguard!
Fidelity is out to undermine Vanguard's market position as low-cost index champion, and this is a battle Vanguard can't win. Since most Fidelity client assets are in actively managed funds, Fidelity doesn't lose too much by cutting fees on its index funds. Fidelity has $41 billion in index funds, out of a total of almost $1 trillion. So Fidelity estimates that it will lose about $40 million in fees due to the cut. But if Vanguard matched the cut, it would lose about $250 million in fees, because Vangaurd has $302 billion of its assets in index funds, out of a total of $730 billion.

Bad news for Barclays!
Barclays is attacking the US retail market with low-cost, index-tracking exchange-traded funds (ETFs). Barclays' iShares S&P 500 fund still has the lowest annual fees (0.09%), but Fidelity now seriously undercuts Barclays' EAFE index ETF, which charges 0.35%, and its total US equity market ETF, which charges 0.20%. And those fees exclude the additional trading costs and spreads that come with ETFs. Prediction: Barclays will cut the expenses on its ETFs within 12 months.

Bad news for E*Trade!
E*Trade is trying to position itself as a low-cost platform for mainstream investors, not just active traders. An integral part of E*Trade's strategy was its claim to offer the lowest-cost available index mutual funds. Poof! Fidelity has made all those full-page E*Trade ads in the Wall Street Journal look dated. Low-cost index funds are a necessary complement to low-cost ETF trades, since investors are then able to make regular contributions to their investment accounts using mutual funds, and then use ETFs for tax-loss selling and rebalancing. But E*Trade must be asking itself whether it has the scale to play in the passive fund management business. I don't think it does.

Bad news for Fidelity!
Fidelity's participation in the index fund wars just raised the hurdle for its own actively managed funds. While Fidelity just succeeded in driving down the cost of passively-run index funds, the costs of actively managed funds are rising. Partly that's due to the aftermath of the mutual fund scandal: active fund managers now have to hire compliance officers and charge fees for early redemptions to eliminate market timing. And partly it's due to the dramatic growth of hedge funds, which has raised compensation levels for the best analysts and portfolio managers. Think of it this way. Fidelity's Magellan Fund charges 0.70% in fees annually, now 60 basis points more than Fidelity's own S&P 500 index fund. Is there a good chance the Magellan Fund can outperform the index after taxes and trading costs by meaningfully more than 60 basis points annually for the next decade? No way.

Good news for investors!

Most wealthy investors mistakenly believe that commodity products are for the low-end of the market. But in A Better Way to Invest, I argued that all investors should embrace commoditized investment instruments - specifically index funds and online trading - because they have the lowest costs, and costs come straight out of investment returns. Let's say you're an affluent investor who wants to allocate 40% of your $10 million account to the S&P 500 and 35% to foreign large cap stocks. Well, Fidelity just raised your annual return by over $8,800.