How Cheap Are Fidelity's New ETFs?

October 31, 2013

Just how cheap are Fidelity’s 10 low-cost, commission-free ETFs, really?

Last week saw the launch of 10 sector ETFs from Fidelity that will be added to the firm’s commission-free list. When combined with the funds’ lowest-in-class expense ratios, this should make these fund supremely attractive. But that’s not necessarily set in stone.

Fidelity unveiled 10 sector ETFs—its first private-label launches since the release of the Fidelity Nasdaq Composite Tracking Stock ETF (ONEQ | B-70), the firm’s often-overlooked 10-year-old Nasdaq composite ETF, which has a robust $264 million in assets. In many people’s eyes, with these latest launches, Fidelity sent a shot across the bow of Vanguard, whose sector ETFs track similar MSCI indexes.

The 10 funds from Fidelity offer an attractive value proposition—on paper at least—for the everyday investor: commission-free trading of the lowest-cost sector ETFs on the market. In a world where investors have been told that the key to maximizing long-term returns is to minimize costs, Fidelity is making quite a compelling case.

The problem with this investment case is it overlooks how these ETFs behave in the real world. Sure, the elimination of trading commissions, whether $9 or $29 a trade, is a welcome development. But the real world has a funny way of making these sorts of commission-free trades nearly inconsequential.

Take the U.S. Financials segment as an example.

Prior to the launch of the Fidelity MSCI Financials ETF (FNCL), the cheapest fund in the segment (from a headline expense ratio perspective) was the Financial Select Sector SPDR Fund (XLF | A-87) at 18 basis points, or $18 for each $10,000 invested. However, when you take into account the real cost of holding XLF—as measured by tracking error in combination with its average spreads, the cost approaches 33 basis points. That figure is more than double the full holding cost of the Vanguard Financials ETF (VFH | A-94).

So what does this more complex cost calculus mean for Fidelity’s 10 new funds?

It’s hard to say, but one thing is certain: Having the lowest expense ratio doesn’t mean you’ll have the lowest holding cost. More bluntly, eliminating commissions does not make an ETF free to trade.

After all, regardless of how much commission you pay, you still must contend with the width of the market you’re targeting. Since the Fidelity products launched with $20 million in assets under management, there’s likely to be very little liquidity in the secondary market for quite some time.

Truth be told, we’ve already seen this show in the exact same segment of the market.

Back in 2011, Scottrade launched a suite of 15 ETFs under the FocusShares brand targeting vanilla equity strategies, including sector funds.

The products, which lasted less than 18 months before closure, undercut the fees of competing products. Unfortunately, a lack of investor interest meant little liquidity and wide trading spreads. In other words, the attractive headline expense ratio—as well commission-free trading—was not enough to pry investor assets away from competing funds.



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