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Don’t Be Fooled by The Fidelity Zero Fee Index Fund

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I admit that this title is a little clickbait for me.  But so is the marketing scheme of a “Zero Fee Index Fund.” When Fidelity says zero fee, it doesn’t mean zero fees.  All it means is that the fund doesn’t pay an expense ratio to the fund manager. They can still charge trading fees, index licensing fees, legal fees and more to the fund.  Also, Fidelity makes money lending securities from the fund to short sellers and very likely does not return the money to shareholders.

The short of it is that Fidelity Zero Fee Index Funds are very good in their own right, but their fees are nothing special in an industry with numerous negative fee Exchange Traded Fund (ETF) index funds.

Short Lending Makes Competing Funds Less Expensive Than the Expense Ratio Suggests

One way that fund managers like Schwab, Blackrock, and Fidelity make money is by short lending.  When someone shorts a stock, they borrow a share of the stock and sell the borrowed share. They then return the share at a later date.  The only way to borrow a share is to pay someone who owns the share. Enter short lending.

Generally, short lending is most profitable with smaller stocks, however many large stocks also are shorted.  Companies like Schwab and Vanguard return either part or all of the short lending revenues to the shareholder. In other words, a Schwab Fund like the Schwab Small Cap ETF (SCHA) will charge an expense ratio to the shareholder but then Schwab will pay the fund back with profits from short lending.  In the case of certain ETFs, short lending can be so profitable that the fund actually has a net negative expense ratio.

Did you hear that Fidelity? We already have negative expense exchange traded funds.  Your zero fee fund has nothing on that.

Of course, it is possible that Fidelity will decide to pay back a portion of any short lending earnings to the shareholders. This was unclear in the Fidelity fund documents, which makes me believe that Fidelity plans to keeps short lending revenue to pay for the costs of the fund.  


Did you hear that Fidelity? We already have negative expense exchange traded funds.  Your zero fee fund has nothing on that.

Informed Investors Everywhere

Expense Ratio Is Misleading.  Use Total Holding Costs Instead.

Fidelity’s new funds are not “Zero Holding Cost” but merely “Zero Fee.”   These two ways of measuring fees are very different due to everything from short lending to controlling other expenses in the fund.

Using Schwab’s small cap ETF, SCHA, as an example, the fund holds small cap stocks and carries an expense ratio of 0.05%.  This means that if you hold $10,000 in the fund, you would expect to pay $5 annually in fees.

Right? Wrong!

In 2017, you would have been paid $61 dollars to hold the $10,000 of the fund.

In other words, expense ratio is very wrong for determining actual holding costs when funds throw back revenues to the shareholder.  I don’t mind paying Schwab $5 to manage my investment when Schwab also gives me back $61 just because they have a good policy on sharing short lending revenues.  This is the equivalent of an expense ratio of -0.61%. That trounces a fund that costs Zero.

Here are some other example of holdings costs of $10,000:

FundAnnual CostHolding Cost %Expense Ratio %
Vanguard Developed Markets ETF (VEA)-$9-0.09%0.07%
Vanguard Foreign Small Cap ETF (VSS)-$223-2.23%0.13%
iShares Total US Stock Market ETF (ITOT)$60.06%0.03%

All data is from 2017.

Clearly, management fees only tell part of the story.  Considering holding cost is much more important. Are you questioning why Fidelity has not clearly published actual holding cost? It’s because with actual holding cost, the Zero Fee index funds start to look much less competitive.  Still good. But definitely not zero.

Capital Gains Taxes Make Fidelity’s Zero Fee Funds Tax Inefficient When Compared to ETF Index Funds

Capital gains are always distributed to shareholders.  Mutual funds are naturally tax inefficient because they always generate some capital gains, unlike ETFs.  Good ETFs like the Schwab Total Stock Market ETF (SCHB) have an expense ratio of 0.03%.  This makes it marginally more expensive than the comparable Fidelity Zero Fee Index Fund in the management cost department.  However, SCHB nevers passes along capital gains because it never trades. I explain why ETFs are more tax efficient in a prior post, and it is a benefit exclusive to ETFs and normal mutual funds do not have this tax benefit.  Assuming a tax rate of 20% on capital gains, anything greater than a 0.15% capital gains distribution at the end of the year will result in the Fidelity Zero Fee product being more expensive than an ETF like SCHB.  The Fidelity Zero Fee Large Cap Index Fund kicked off a capital gains distribution equal to 0.12%, making it so most of the benefit of the fund’s low fees were eaten up in capital gains taxes. If you fall in a lower capital gains tax bracket, then you will find the Zero Fee Funds more compelling options.

Of course, if you hold the fund in an IRA, this is not an issue and the Fidelity Zero Fee product will win the management fee race by 0.03%.  

When Competing To Lower Fees By Minuscule Amounts, Tracking Error is More Important

When dealing with small expenses, the change in fees is truly negligible, even for large accounts in the billions of dollars. This is counterintuitive, but the reason is that other issues with funds will have a much larger effect on the outcome.  For example, tracking error will be a larger determinant of how well a fund does than cutting the final 0.02% fee from a fund like the Schwab S&P 500 Index Mutual Fund (SWPPX). This fund only charges 0.02%, but its tracking error is excellent and kept to a minimum, meaning it almost matches the actual index.  If the Fidelity Funds are unable to match the index, you could easily lose much more than the 0.02% saved by switching from the Schwab Fund.

Are Fidelity Zero Fee Index Funds a good deal?

Yes.

And they have the added benefit of having no minimums, similar to Schwab.

Are they as good of a deal as Fidelity wants you to think?

No.

Simply put, the Fidelity Zero funds are great mutual funds that utilize dishonest marketing gimmicks by misleading potential investors about how low its fees actually are compared to other funds.  Many news sites released articles claiming that the race to the bottom has now been won and there is nowhere else to go. Hate to break it to you Fidelity, but zero is not the smallest number. Elementary school should have taught you that every negative number is smaller than zero. Because of how numerous funds by Schwab, iShares, and Vanguard return short lending revenues to shareholders, numerous funds already have an effectively negative fee fund in a more efficient ETF structure.

Zero is not the smallest number.

Says an anonymous second grade math teacher trying to teach Fidelity, a struggling second grader, how negative numbers work. Sadly, Fidelity doesn’t get it and might be held back from moving into third grade.

That said, Fidelity Zero Fee Index Funds are great products and are a good buy.  Just don’t be fooled into thinking they are somehow cheaper than other index funds out there.  Also, if you hold other Fidelity funds, beware. Fidelity is most likely charging more in fees on your other funds to cover the cost of the Zero Fee Index Funds.  

As for me, I’ll pass on Fidelity’s Zero Index Funds. I will stick to low cost ETFs.

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Kelton Johnson

Attorney, Marketing Enthusiast, Business Manager

I live in Orange County, California and can often be found wandering the coastline and mountains in Southern California. I always seek to learn new things and share my passions with others. I am a California-licensed attorney and internet marketer. Join me in my journey of discovery as I share (hopefully) useful gems of knowledge with my readers every week.

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