Camp Kotok: Zero Ain’t Your Hero

August 06, 2018

Cover photo courtesy of Leen's Lodge

Each year, 50 or so economists, financial advisors, asset managers, analysts and politicians gather in the Maine woods at the invitation of Cumberland's David Kotok to discuss the state of the economy, of markets, and even the world.

Discussions happen over fishing, over dinner and once or twice during the weekend, during more formalized debates and discussions. The discussions are conducted under the Chatham House Rule—participants can report on the sense of the group as a whole, or the facets of a debate, but may not attribute to individuals without consent.

Most of the time the conversation revolves around fundamental economics: monetary policy, trade policy and so on, and there was definitely much discussion on those topics this year as well. But this year, one announcement by one firm seemed to dominate the discussions: Fidelity’s decision last week to make two index mutual funds available at a headline expense ratio of zero.

 

Fidelity's front page right now

 

The Problem With Zero

Plenty of ink has already been spent dissecting Fidelity’s move here (here’s a great article by Nate Geraci at ETFPrime.com on the topic), and I won’t rehash it here. The bottom line is the actual difference in utility of a 0.03% ETF or a zero basis point mutual fund is largely irrelevant.

From an investor perspective, your experience in the funds will vary from the stated benchmark, just like pretty much all ETFs do. Even the cost leader Schwab U.S. Large Cap ETF (SCHX), with a stated fee of .03%, actually trails its index not by that .03%, but between .01% (yeah!) and .06% (boo!).

So the Fidelity funds are loss leaders, and of course, your investment experience won’t be precisely “zero.” Heck, with a good securities lending program, your experience could actually be better than zero.

After all, in a good year, the iShares Russell 2000 ETF (IWM) doesn’t “cost” the headline 0.19% a year; it actually pays you .04%. How? By lending out the securities in the portfolio to short-sellers. That securities lending generates 0.25% in income in a good year, more than offsetting expenses.

This “everything is free” mentality was one of the major themes, at least for me, in discussions at Camp Kotok. And while the “race to zero” is great for consumers, there were some real concerns raised at the event:

Whither Innovation?

If beta is becoming free, the job for active managers isn’t just more difficult in terms of justifying fees—it’s actually more difficult period. While margins in investment management remain strong, they’re crashing down toward the ground as fees come down.

That makes the development of new investment approaches, new asset classes, and so on, untenable in a traditional “retail” package. Instead, innovation will likely end up holed up inside institutional products—particularly hedge funds—where there may be more willingness to pay for performance.

The irony here is that ETFs (and index mutual funds) really started out as institutional vehicles in the first place, and yet the efficiencies brought about by their success may actually push institutions toward the fringe as they seek to generate returns beyond beta.

Serving The 10%

There was much discussion about what “free beta” means for the financial advisor business, and the most salient comment of the weekend was likely this: While pundits and journalists often write for the mom-and-pop investors, and fund companies make product for them, the cold hard reality is that 84% of the stocks in the U.S. are owned by the top 10% of the wealthy.

The consensus among financial advisors in the room was that strong practices focus not on the “solved problem” of basic asset allocation and investment management, but on true financial planning, from estate planning to philanthropy.

Trickle-Down Economics

Looking to the future—what are the implications for a world with radically lower investment management fees?

First, it’s inevitable that investors will pay for their “free” investment management in other ways. Nothing is ever truly free. Fidelity (and the ETF and mutual fund issuers who will, inevitably, chase them to the bottom) will simply have to make up the lost revenue elsewhere.

The good news for a firm like Fidelity is that it’s deeply vertically integrated. Investors can use Fidelity for essentially any financial need, from life insurance to cash management and bill paying. Firms with similar breadth—Schwab and Vanguard in particular—have an edge in the race to the bottom. Whether it’s explicit charges for services, or simply making margin on cash balances, they can take the hit.

Firms without that breadth—traditional asset managers like, say, BlackRock or Van Eck—have a different problem. They can’t really run to zero and hope to make it up elsewhere—not when they don’t actually own the customer relationship.

The Big Next Step

While the consensus of folks I talked to at Camp Kotok is that other firms will follow suit, it will likely be a pretty limited set of funds and strategies. Brand name does matter to investors, and the “self-indexed” variety on offer so far from Fidelity will have somewhat limited appeal. So how low can it go?

To me, the ultimate “unbundling” will occur as firms eschew the fund structure altogether. Firms like M1 Finance are already starting to break the mold of what a “fund” even is, allowing investors to subscribe to security lists and then own them as fractional shares. Instead of owning an S&P 500 ETF or mutual fund, I see a world where I simply “subscribe” to the S&P 500, and the actual implementation is handled at the single-stock level by my broker.

If that seems far-fetched, it’s already reality for M1 and some robo advisors like Wealthfront. It has a few real advantages—the ability to easily skew a portfolio along environment, social, governance lines, and single-stock tax-loss harvesting, to name a few. Such a structure gets rid of the last middleman (the fund issuer itself), and creates a direct relationship with the actual investment intellectual property (the index or portfolio manager).

Mind The Gap

So where does this leave actual investors, if not lost in the Maine woods fishing?

The biggest caution I have is that this fetishization of expense ratio has a point of diminishing returns. While it’s absolutely the case that—all else equal—lower costs are better, it’s important to remember that all else is rarely equal.

I don’t expect billions to follow into these new Fidelity products overnight—but I’m certain they’ll be successful and engender a rash of copycats. So put on the good reading glasses and get into the details before you get lured in by the siren song of “zero fee.”

Dave Nadig is managing director of ETF.com. He can be reached at [email protected].

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