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This Mutual Fund Giant Is Now Offering a Zero-Fee Index Fund. So What's the Catch?

By:
Rob Curran
6 min read
A sign outside of a Fidelity Investments office in the Century City section of Los Angeles. - AP;REX/Shutterstock
A sign outside of a Fidelity Investments office in the Century City section of Los Angeles. AP;REX/Shutterstock

Retirement giant Fidelity wants to let you invest for free. But should you?

Earlier this month the Boston-based mutual fund company launched Fidelity Zero Total Market Index Fund and the Fidelity Zero International Index Fund, two new index funds Fidelity says will charge investors nothing.

The new funds -- designed to give investors broad-based exposure to U.S. and international stocks, respectively -- are the result of a years' long price war between Fidelity and other big U.S. fund managers including BlackRock, Vanguard and Charles Schwab.

For many shoppers the term "free" has an almost magical quality. That's doubly true for retirement investors who've had it drummed into them that costs, above all else, are the key to evaluating an investment.

(Fidelity says the funds are a loss-leader designed to attract customers to other products like retirement income annuities, which it will continue to charge for.)

So are the new funds a can't miss opportunity? Not necessarily, say investing experts like Ben Johnson, who oversees index investing at fund researcher Morningstar.

“If anything," he says. "There’s a risk that people could be a penny wise and a few pounds foolish if they were compelled to switch."

The backstory

While index, or passive, investing has always had its fans, the strategy's popularity has exploded in the decade since the financial crisis. As a result, nearly half of all U.S. stock investments are now in low-cost passive investments, according to a study in the Bank of International Settlements quarterly review.

Big mutual fund companies have responded by launching a price war that some investing pros have dubbed the "race to zero." While Fidelity's new zero-fee funds mean it's won the race, in some ways, the race was already won years ago -- by investors.

When the first passively managed index fund arrived on the scene a generation ago, the average mutual fund expense ratio was close to 1%, according to Vanguard’s Web site. Today, even before Fidelity's move, fund expenses are counted in one-hundredths of a percentage point. Schwab Total Market Index has a 0.03% expense ratio; Vanguard Total Market Index has a 0.14% expense ratio; the same firms’ international index funds are a few basis points higher.

“When you go from paying a percentage point a year for the privilege of investing in a fund to paying [almost] nothing that’s a really big deal,” says Morningstar's Ben Johnson. “When you go from paying 0.04% to invest in a fund to paying nothing that’s far less exciting -- that’s $4 a year worth of savings on $10,000 investment.”

Take A Look, but Consider Other Factors

While a fund's cost should always be a factor in your investment decisions, in today's hyper-competitive market it shouldn't necessarily be the biggest one, says Oliver Pursche, a Bruderman Brothers investment strategist.

Among others: What specific stocks the fund holds, to a large part determined by the particular benchmark it tracks, and a factor that investors call "tracking error," which is essentially how close the fund comes to actually matching the performance of its benchmark.

“The risk of investors becoming overly obsessed with fees is that they overlook differences” that could be much more significant in the long run, says Johnson.

For instance, over the past decade Schwab Total Market Index Fund, which charges investors 0.03% of assets a year, or $3 per $10,000 invested, has returned 10.62% a year, on average, according to Morningstar. By contrast, the Fidelity Total Market Index Investor, which charges investors 0.02%, or $2 per $10,000 invested, has returned 10.53%.

Many investors should now be able to get a fund equivalent to Fidelity Total Market Index Investor for free. But the benefit of that -- equivalent to boosting the Fidelity fund's return by 0.02 percentage points a year -- wouldn't have been enough to overcome the Schwab fund's long-term outperformance.

When Morningstar back-tested the 10-year performance of Fidelity, Schwab and Vanguard's total market funds, it found that, even during the race to zero, the spread on returns was minimal.

Don't Forget About Uncle Sam

Investors who already own a Vanguard, Schwab or other index fund but are thinking of switching to a free Fidelity one have at least one more thing to consider if their savings are stashed in a taxable brokerage account, as opposed to a tax-advantaged retirement one like an IRA or 401(k).

Selling one fund to buy another typically prompts a capital gain -- and with it a potential tax bill, points out Morningstar's Johnson. "Jumping ship could potentially be very costly,” he says.

Still, even if the new Fidelity funds aren't an immediate game changer for your portfolio, they could still have a big impact on investment world in years to come.

Just as consumers have come to expect free news online and free Wi-Fi at coffeeshops, they may now expect to buy broad-market exposure for nothing – or next to nothing, says Johnson.

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