Don’t Obsess About Expense Ratios
Fidelity’s New 0% Expense Ratio Mutual Fund
A few days ago Fidelity introduced the first 0% Expense Ratio on a mutual fund, specifically a total stock market index fund tracking their own made-up index. This was the logical progression of a marketing strategy that they, along with Charles Schwab, have used over the last few years with limited success in order to compete with Vanguard, who made their name and became the world’s biggest mutual fund company on low-cost index funds. It looks like this:
Basically, here is the way it works:
- Vanguard Admiral Shares Total Stock Market Index Fund – ER 0.04%
- Fidelity Total Market Index Premium Fund – ER 0.015%
- Schwab Total Stock Market Index Fund 0.03%
and all of a sudden the investor who has been told that “expenses matter” assumes that differences of 1-3 basis points matter. Yes, they matter, but not very much. And in fact, once you’ve gotten down to differences of less than 10-20 basis points, they matter a whole lot less than some other things. That principle still applies with the natural continuation of this strategy that is happening over at Fidelity. If you missed it, it looks like this:
Based on the number of people who are actually thinking about changing their investment holdings based on this change, I would say that this MARKETING STRATEGY is working very well. Notice I said marketing strategy, not investing strategy. (A more cynical investor might even call it a publicity stunt.) There is no new investing strategy going on here. It’s the same old, same old investing strategy – buy all the stocks, hold them, keep your costs and taxes down, and in the long run, your money grows at the same rate as the market and if you save enough, you become financially independent.
So let’s talk about what’s really going on here. Let me lead you through a little logic.
- Vanguard has the largest index funds, thus they benefit the most from economies of scale.
- Vanguard operates at cost.
- Therefore, an index fund that charges less than Vanguard is operating at less than cost. Thus, it is a money loser. (And no, I don’t buy the argument that Fidelity just runs a more efficient operation with a fund 1/14th the size.)
- A for-profit business only loses money on a product line for two reasons: either it will soon make money on it or it hopes to make it up elsewhere.
- If your strategy is to attract the non-sticky money using a very slightly lower ER, and then you raise prices, that same non-sticky money will then leave you.
- Therefore, the only possible reason for Fidelity/Schwab/etc to charge less than it costs to run a mutual fund is so they can make money on their other products.
Now, ask yourself the following:
- “Do I really want to support a business doing that with my investment dollars in order to save 1-4 basis points?”
- “Would Fidelity/Schwab/etc be doing this if it wasn’t for Vanguard giving investors a fair shake on Wall Street?”
What Matters with Index Funds
The other thing to keep in mind, of course, is that expense ratio is not all that matters when it comes to index funds. There are really only three things to pay attention to here:
- What index?
- How well does the fund track it?
- Do I get other benefits like tax-efficiency, simplicity, status (Flagship) etc?
Notice that expense ratio isn’t on that list. That’s because it is baked into # 2. The higher the cost, the less well the fund tracks its index. Also, bear in mind that if you’re investing in a taxable account, the return you care about is the after-tax return.
Let’s look at a few examples, using fairly long-term returns (15 year annualized returns as of 6/30/18) and a neutral source (Morningstar.)
Oh crap. What does that tell you? Well, it essentially refutes the hypothesis that a lower cost index fund provides higher returns. I’m not going to argue that 9.77% is significantly different from 9.71%, but that’s essentially the point. Once you get expense ratios “low enough,” you should no longer focus on them. That fact isn’t going to change just because the number is 0.00% rather than 0.03% or 0.015%.
“But wait,” the critic says. “Fidelity and Schwab didn’t lower their ERs until more recently.”
Okay, let’s look at 1-year returns from the same source.
Nope. It just turns out that Vanguard is better at indexing than Fidelity and Schwab. Is that really a surprise to anyone? Let’s dive into the details here a bit.
The Vanguard fund tracks the CRSP US Total Market Index while the Fidelity fund and the Schwab fund track the Dow Jones US Total Stock Market Index (and the new Fidelity fund will track its own proprietary index.) Well, which index has the highest return? It turns out there is a correct answer to this question, which some very dedicated Boglehead wiki editor has compiled.
As you can see, the total market index with the highest return is the Wilshire 5000. But whether the CRSP or the Dow Jones is a higher performing index depends on the time period you look at it. At 5 years, CRSP wins. At 15 years, Dow Jones wins. To make matters even more complicated, these index funds CHANGE which index they’re following from time to time. The Vanguard fund used to follow the MSCI index, for instance. But the MSCI index has only been around since 2004, the year I started investing. That means the fund used to track a completely different index.
My point is that which index you track matters a whole lot more than a couple of basis points in expense ratio.
How Well Does A Fund Track Its Index?
Not only does the index matter, but how well it tracks its index matters too. This information is readily available on each company website:
The index is spliced to reflect the fact that they’ve tracked multiple indices in the past. But as you can see, Vanguard does a VERY good job of tracking its index. In fact, the tracking error (0-0.02% depending on time period) is less than the expense ratio. How can they do that? Well, that’s one advantage of being big. Not only do you benefit from economies of scale, but you also have a lot of stocks to lend out to short sellers, and because you’re running it at cost, you pass those benefits on to the shareholders.
Don’t worry, Fidelity and Schwab do a fine job of tracking their index too, maybe even a better job than Vanguard.
But there are index funds that do a terrible job. Check out the Rydex S&P 500 fund.
Yea, that’s right. It underperformed its index by 2.5% per year over 10 years. The fact that this fund still exists might be the best example of a lack of financial literacy among investors that I know of. 2%+ for an index fund ER. Unbelievable.
So, now that we’ve seen that the difference in expense ratios among Vanguard, Fidelity, and Schwab matter far less than which index is tracked and how well it is tracked, let’s consider some other factors.
Vanguard has a HUGE advantage here, as it can “flush” its capital gains out by using its ETF share class, which Fidelity and Schwab do not have. Consider the after-tax returns for the last 5 years (once more, this is all per Morningstar as of 6/30/18):
Now I’m not going to argue that 1-3 basis points matter much, but 23? You’re starting to get my attention now.
Let’s say you’re not just investing in a basic 3 fund portfolio. You actually want a half dozen or more asset classes in your portfolio. Such as small cap value. Oh wait, Fidelity doesn’t have a small value index fund. Neither does Schwab. Yet Vanguard has had one for two decades. Maybe a better strategy for Fidelity would be to offer index funds in asset classes that Vanguard doesn’t (International Small Cap Value anyone?) rather than getting a “me-too”
drug fund and spending all its money on marketing instead of research and development.
I’m amazed to hear about investors thinking about switching from the Vanguard to the Fidelity Total Stock Market fund, or worse, switching to the brand new 0% ER Fidelity fund. That’s not even worth my time to fill out the rollover paperwork, especially since I’ll then have assets at both institutions (or else pay fees each time I buy and sell the other’s fund.) That’ll make rebalancing fun. And to pay capital gains taxes in order to switch? Now you’re really making a mistake.
In addition, spreading your assets among multiple institutions will also delay the time it takes to reach “fancy-pants” status at that institution. At Vanguard, Flagship status ($1M invested) gives you a personal representative, some free advice and trades, and some other assorted minor benefits. Fidelity has something similar (Private Client), but it’s not nearly as good, like most of what is at Fidelity.
Should You Switch? The Bottom Line
If your money is already at Fidelity or Schwab and you have a simple portfolio, go ahead and use their index funds guilt-free, especially if you’re in a tax-protected account. But if your money is at Vanguard like mine, there is absolutely NO reason to switch based on trivial differences in expense ratio. And you certainly don’t want to pay any capital gains taxes to switch one way or the other. The reason that Vanguard is the biggest mutual fund company in the world is that they’ve earned the trust of millions of investors by doing the right thing over and over and over again. Are they perfect? Not even close, but ownership matters, and in the case of Vanguard, you’re the owner. Show a little loyalty to your own company. They’re still doing the right thing.
What do you think? Were you impressed by these ER reductions? Why or why not? Comment below!