Earlier this month there was an uproar in the financial news media that was interesting because:
- For once, it had nothing to do with Trump and
- It wasn’t bad news
Fidelity, the Boston-based investment group with $2.4tn under management, last week announced that it was cutting the cost of all its passive, index-tracking mutual funds, and introducing two new ones that boasted an expense ratio of zero — in other words, the first free investment funds.
Fidelity Investments just beat all of the low-fee index fund competition to a move long expected: It will be the first fund company to offer core index funds without any management fee.
Retirement giant Fidelity wants to let you invest for free. But should you?
Which of course triggered a flood of emails into our inbox asking about these things, so I thought now would be a good time to address this.
What is it?
First of all, if you don’t know why low-cost Index funds are a Very Good Thing, check out our Investment Workshop. Because not paying high investment fees is the easiest, most reliable way to boost your portfolio’s performance, these things are the building blocks of any self-respecting aspiring (or current) early retiree striving for Financial Independence.
Ever since the 2008 stock market crash proved the relative uselessness of active portfolio managers, the popularity of Index funds has grown until now about half of all US funds invested in equity are invested in passively managed Index funds, mostly led by Vanguard. Now that it’s no longer possible to dismiss passive investing as a temporary fad, that’s forced other fund companies to offer low-cost Index funds as well or risk seeing their assets-under-management get hammered. It’s also caused a bit of a race-to-the-bottom when it comes to investment fees as each company attempts to one-up (or one-down?) each other.
Well, now it looks like Fidelity has won said race-to-the-bottom by offering a pair of Index funds which have fees of 0%. That’s right, 0%. And they are the Fidelity ZERO Total Market Index Fund (FZROX) and the Fidelity ZERO International Index Fund (FZILX).
What’s the Catch?
So what’s their deal? It still costs at least some money to run these things, so why would they be willing to take a loss?
According to Fidelity themselves, they’re doing it to bring customers onto their platform.
Cleverly, when Fidelity made FZROX and FZILX, they chose not to structure them as ETFs. They’re mutual funds. The key difference here is that ETFs are bought or sold on the stock market, so owning an ETF can be done at any brokerage company that can trade on the stock market. Mutual funds, on the other hand, can generally only be owned by opening up an account at that specific company.
So the only way to gain access to this fund is you have to transfer your money into Fidelity. That’s the catch.
It’s a common tactic in the retail world, known as loss leading. Here’s how it works: A grocery store advertises a sale on cereal. You think, “Yay! Cereal!” So you go and pick some up. But when you’re there, you realize you’re also out of milk, and since you can’t eat cereal without milk, you buy some at regular price. And while you’re at it, you pick up some bananas and other stuff too. So the grocery store took a loss when they sold you the cereal to get you into the store, but then made up for it with the other stuff you bought at regular price.
In this case, FZROX and FZILX are loss leaders. They’re taking a loss hoping you transfer all your funds over, and then they’re going to try to sell you on their other funds (which have a steeper MER), or maybe some professional active management advice if they notice you’re a big enough account.
Is This a Good Idea?
While equity funds are a major part of your overall portfolio, they aren’t the only part. You still need bonds, and that’s where using Fidelity starts to not make sense. If we were to take our workshop 60/40 portfolio and switch everything over to Fidelity, this is what our fees would look like.
|Fidelity ZERO Total Market Index Fund||FZROX||30%||0%||0%|
|Fidelity ZERO International Index Fund||FZILX||30%||0%||0%|
|Fidelity Total Bond Fund||FTBFX||40%||0.45%||0.18%|
|TOTAL PORTFOLIO MER||0.18%|
Now compare this to our Workshop portfolio built with Vanguard ETFs
|Total Stock Market ETF||VTI||30%||0.04%||0.012%|
|TFSE All-World Ex-US||VEU||30%||0.11%||0.033%|
|Total Bond Market ETF||BND||40%||0.05%||0.02%|
|TOTAL PORTFOLIO MER||0.065%|
So even though we’ve eliminated fees for our equity funds, using the Fidelity bond fund actually made our total portfolio MER go UP, to double what it used to be!
Should You Switch?
Now, I’m not claiming Fidelity is doing anything unethical, or even wrong. Just that they’re using a tried-and-true marketing tactic known as loss-leading to try to bring in more business for their other products.
However, it might make sense to open up a Fidelity account and ONLY move the equity portion of your portfolio in while leaving your bond portion with Vanguard. Then, using a free tool like Personal Capital, aggregate the two accounts into one screen so you can still view investments as one giant portfolio. Rebalancing might take a bit more work since you’ll have to move money back and forth between the two companies, but since you typically rebalance only once a year that might not be too bad.
That being said, I’d be extra careful of a few things if you were to go down this route:
Caveat #1: Capital Gains
If you sell your Vanguard ETFs and buy Fidelity ones inside an Individual Trading Account, you’re going to create a taxable event. If your investment has gone up in value, capital gains taxes will be due. To get around this, you can consider harvesting your capital gains gradually to take advantage of the 0% tax rate on the first $77k of LT capital gains. Our good friend and fellow FI blogger MadFientist wrote an excellent article on how to do this here.
Caveat #2: Don’t Split up Your 401(k)’s
If you, for whatever reason, have both equities and bonds in a tax-deferred or tax-sheltered account like a 401(k) or a Roth IRA, don’t do anything silly like open up another Roth IRA in Fidelity and try to run one IRA for your equity and another for your fixed income. Just trust me on this, it will be an absolutely monstrous pain in the ass.
When you rebalance, transferring between Individual Trading Accounts is relatively easy. Just do an ACH transfer into your checking account, then another ACH back out. But for a 401(k) or an IRA, this will involve tons of forms, and more importantly cost you money each time you transfer. And oh yeah, if you screw up a transfer it maybe get counted as an early withdrawal and you’d be subject to income tax on the transfer amount as well as a 10% Federal tax penalty if you’re below the age of 59 1/2.
Just trust me on this. Don’t split up your retirement accounts.
So there you have it. Fidelity Zero-Fee Funds. A good product, a GREAT product even. But only if you can avoid the siren song of moving all your money over and buying into other higher-fee products, and if you can do it without complicating your finances in a way that will cost you more than what you’d be saving.
What do you think? Yay or Nay on the Fidelity Zero-Fee Index Funds? Let’s hear it in the comments below!
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