Are Fidelity’s Free Funds Really Free?

August 17, 2018

Dividend Reinvestment

While ETFs avoid capital gains and buffer their ongoing holders from the market impact of creations and redemptions, mutual funds have the upper hand when it comes to dividend reinvestment. Most mutual funds and brokerage firms offer the option to reinvest all cash distributions at NAV, on the fund’s ex-dividend date. This seamless transaction keeps mutual fund clients fully invested at all times.

ETFs cannot do this, even if their portfolio managers wanted to, since ETF issuers do not keep shareholder records. This means that ETF investors have to wait until the cash distributions hit their brokerage account as cash before they can use it to buy new shares. Some brokerage firms offer dividend reinvestment services for some ETFs, others not so much.

Total Cost Of Ownership

For mutual funds, total annual cost of ownership is a function of tracking difference and tax impact. The new zero-fee funds could be exposed to both, because of flows impact and rebalancing.

Flows are likely to be one-way at the outset, as the “free” headlines draw capital. Because of the timing mismatch, FZROZ and FLILX’s portfolio managers are likely to be selling shares on day one, and buying portfolio securities on day two, which will create some tracking difference. But there’s an upside to the one-way flows: no redemptions. This means that, for the first year or so, portfolio managers will not generate capital gains because of shareholder activity. So the likely impact of flows will be on tracking, but not on taxes.

Then there’s rebalancing. The new Fidelity funds will likely have slightly higher rebalancing costs compared to existing Fidelity index funds operating in the same markets. While both FSTMX and the new FZROX cover the vast majority of the U.S. stock market, FZROX’s index methodology includes only up to 3,000 U.S. firms, while FSTMX includes 3,402, with a turnover rate of just 2%. We can probably expect FZROX to behave similarly to Russell 3000 trackers, or to Schwab U.S. Broad Market ETF (SCHB), which had recent annual turnover in the 4-11% range. While it is difficult to estimate the tax impact, it’s not hard to predict that there will be some. 

For investors in taxable accounts, FZROX’s tax and tracking costs will make ETFs a more efficient option. Fidelity stands a much better chance of attracting tax-deferred assets to its new zero-fee funds. Even there, though, the burden is on Fidelity to limit tracking difference, lest operational costs destroy its expense ratio and NAV-based transaction advantages.

For now, tax-deferred and low-bracket investors can weigh the trade-offs, while benefiting from Fidelity’s move, as competitors such as Vanguard, Schwab, and BlackRock face pressure to match Fidelity on pricing.

In memory of Peter Berck, 1950-2018, who reviewed this article on his final lucid day.

At the time of writing, the author held no positions in the securities mentioned. Elisabeth Kashner is director of ETF research and analytics for FactSet.

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