Recently, Fidelity made a splash by launching two index mutual funds that charge no fees. In some ways, this is huge news, as the zero percent price tag confirms that the price war in asset management fees is truly a race to zero. [ETF Prime Podcast: Fidelity Goes To Zero]
Vanguard, Schwab, and BlackRock now have to decide whether to give up their remaining minuscule fees in the face of direct no-fee competition.
But are Fidelity’s zero-cost funds actually free to hold?
The True Cost Of Index Mutual Funds
The new Fidelity 0.00% funds will likely cost high-bracket investors between 0.05% and 0.10% for the U.S. fund (FZROX) and about 0.50% for the international fund (FZILX), based on the historical operating costs of parallel Fidelity funds FSTMX and FTIGX. The story might be slightly different in tax-deferred accounts. Without taxes on capital gains, FZROX may be nearly costless, but FZILX will likely still cost around 0.39% per year.
Fund fees are only part of the equation. FactSet ETF Analytics has designed a total annual cost-of-ownership metric that combines tracking difference and trading costs, and also allows for tax impact. As the table below illustrates, portfolio trading costs and capital gains taxes can often weigh heavily on after-tax mutual fund returns, in this case more heavily than trading spreads do on ETF returns. Vanguard mutual funds are a special case, as they share a portfolio with Vanguard ETFs, and can use some of the ETF advantages to reduce or remove impacts of rebalancing and flows on tracking difference and capital gains charges.
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We will walk through the cost elements one by one, but before we do so, it’s useful to understand why these differences occur. It’s all about the creation and redemption of fund shares.
ETFs Are Actually Mutual Funds, But Different
The majority of ETFs are special types of mutual funds, having been granted exemptions from a handful of SEC 1940 Act rules. Mutual funds transact in cash, via the asset manager, while ETFs are created and redeemed in kind, by specialized agents who exchange a basket of portfolio securities for ETF shares, and, in turn, trade ETF shares with the public. Cash vs. in-kind creation/redemption drives differences in trading, tax treatment, flows impact, and handling of distributions.
Vanguard offers the best of both worlds, because its ETFs are actually share classes of its mutual funds. Vanguard portfolio managers use the ETF creation/redemption process to rebalance the entire portfolio, thus conferring Vanguard mutual funds with the tax and tracking efficiency of its ETFs.
Let’s look at each of these differences, one at a time. We can trace costs to each structure along the way.
For longer-term investors, the trading requirement of ETFs is a burden, rather than a draw. ETFs often trade at a spread around their net asset value (NAV), and sometimes at a premium or discount. Brokerage fees may be added on as well. No such issues with buying or selling shares in a mutual fund.
Even the largest, most liquid, cheapest, broad-based vanilla ETFs will set investors back a few basis points in spreads and sometimes in premia to NAVs.
Comps Source: User-Defined Comparables U.S. Dollar
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Yet these trading costs can be worth bearing in exchange for the vehicles’ tax efficiency, especially for long holding periods, as they can be amortized.
ETFs Escape Most Capital Gains
ETFs rarely distribute capital gains, for two reasons. One, ETF portfolio managers are often able to rebalance portfolios by offloading low-basis positions in kind, via the redemption process. Two, ETF investors are insulated from their co-owners’ actions. Cash creations and redemptions expose mutual fund portfolios to both types of capital gains, which must be distributed to fund holders.
The now well-documented “heartbeat” flows enable ETF portfolio managers to rebalance without incurring capital gains charges.
Mutual fund portfolio managers must rebalance directly, by selling portfolio securities and buying new ones. Selling winners means realizing capital gains.
Mutual fund shareholders are on the hook for all realized gains, even for positions initiated long before their own purchase date. Mutual fund shareholders are also on the hook for the tax consequences of fellow shareholders’ redemptions. Mutual fund portfolio managers often have to sell securities to raise cash to meet redemptions. The buy-and-hold investors pay the taxes for the redeemers. Ouch.
That’s not an issue for ETF holders. ETF redemptions are mostly made in kind, generally as a pro-rata share of portfolio securities. The redeeming parties, including the investor and the associated person/market maker, complete the process by selling the securities in the capital markets. No capital gains involved.
There’s another, subtler way that cash creations and redemptions cost mutual fund shareholders, while in-kind transactions place the costs directly on the transacting party. The effects are measurable as tracking difference.
When fund shares—mutual fund and ETF—are created or redeemed, someone has to buy or sell portfolio securities. The trades create a market impact, pushing the prices of purchases up, and depressing the sale price. This impact is spread among mutual fund shareholders, but falls solely on the ETF buyer or seller, without impacting the remaining shareholders.
Because ETF creations and redemptions happen in-kind, a purchaser or seller’s agent must transact in the capital markets, bearing the market impact. The ongoing fund holders do not bear the trading costs or suffer the market impact.
For mutual funds, the capital markets transactions happen after shares are issued or redeemed. For ETFs, capital markets transactions come first, and issuance second. ETFs are very efficient except on the day you buy or sell them. Mutual funds are the other way around.
To meet a purchase order, mutual fund portfolio managers deliver shares at NAV before buying portfolio securities. The new purchases may well cost more than they would have the previous day, by virtue of the presence of the buyer. Trade-day NAVs do not yet incorporate the market impact of the new purchases or sales. The market impact is measurable by tracking error.
This becomes clear when we look at three-year annualized total returns for S&P 500 funds. The three U.S.-domiciled S&P 500 ETFs—the iShares Core S&P 500 ETF (IVV), Vanguard S&P 500 ETF (VOO), and SPDR S&P 500 ETF Trust (SPY)—returned an average of 0.08% per year more than the average of 15 no-load, investor class S&P 500 mutual funds. That’s after the expense ratio was added back in.
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.