Remember when the biggest obstacle to successful investing was high costs? Whether it was mutual funds with exorbitant fees or brokers gouging you with commissions, the entire investment industry was for decades an elaborate way of transferring wealth from Main Street to Bay Street. Unless you were extremely savvy, you didn’t stand a chance as a retail investor in that environment.
The investment business will always be fuelled by ego and greed, but today, there are more low-cost options than ever. In fact, if recent trends continue, it may soon be possible to build and maintain a portfolio for free.
The first barrier to fall was trading commissions, which have dropped from about $29 only a few years ago to less than $10 today. Some online brokerages even allow you to trade exchange-traded funds (ETFs) with zero commissions and no account fees, and the robo-adviser Wealthsimple has just announced it will soon offer free stock trades, too. All of this allows even the smallest investors to get access to the markets like never before.
Now, it looks like we’re close to seeing fund-management fees disappear, too. In August, Fidelity Investments in the United States became the first fund provider to offer a family of index funds with a management fee of zero per cent, and no minimum investment.
Some industry experts think we’re only a short step away from index funds and ETFs with a negative fee. That’s right: The fund would pay you to manage your assets. It’s starting to feel like we’re in the Upside Down, the alternate dimension in the Netflix drama Stranger Things.
So will a zero-fee universe make us all successful investors? We can hope, but I’m not sure it will improve as many lives as it should.
The fact is, super cheap investing options have been available for years. All of the major ETF providers in this country offer broad-market Canadian equity ETFs with fees of 0.06 per cent or less. That’s $5 a month on a $100,000 portfolio – not zero, but less than one small Tim Hortons coffee a week. ETFs listed on U.S. exchanges are even cheaper, and if you include GICs in your portfolio, you can push your costs lower still.
Bottom line, you can already build a globally diversified portfolio for negligible cost. So if you’re a cost-conscious DIY index investor, reducing your fees from a few basis points to zero is an incremental improvement, not a fundamental shift. And if you’re a committed stock picker, or if you work with an adviser who picks stocks and funds for you, then further fee reductions on index funds are unlikely to have any effect on your financial plan. In my years as a financial journalist and adviser, I have met every conceivable objection to index investing, but I have never heard anyone say, “I would be an indexer if it weren’t so expensive. If the fund companies and brokerages would just reduce their fees to zero, I would embrace the strategy.”
Nor will a modest decline in fees do anything to prevent the biggest mistakes investors make: timing the markets, forecasting interest rates, misjudging their risk tolerance and forgetting that everything starts with disciplined saving. Even passive ETF investors have a tendency to make too many transactions, and commission-free trades may even encourage more tinkering.
I’m also skeptical of ulterior motives, because nothing is really free. We need to ask, if they offer index funds with no fee, how will the investment firms earn their profits?
The source of revenue for zero-fee index funds will likely be securities lending, which is the practice of charging interest on shares loaned to short-sellers. For huge-fund providers, this revenue can be significant: some U.S. funds hold more than US$10-billion in assets, so even 0.01 per cent earned from securities lending could generate more than $1-million in annual revenue.
Many funds lend securities: ETF.com has reported that 60 per cent of ETFs in the United States engage in the practice while calling it “the best-kept secret in the ETF business.” It’s not especially risky, since lenders insist on high-quality collateral. But as fund companies face pressure to lower fees they’ll have an incentive to do a lot more of it, and they may loosen their standards and take greater risks as they look for ways to replace lost revenue. At least fees are transparent.
It’s also worth noting that Fidelity’s new zero-fee index funds do not track benchmarks created by third-parties, such as S&P and MSCI. Index providers charge licensing fees, so Fidelity has created its own to avoid these costs. This isn’t necessarily a bad thing: You can certainly argue that popular indexes such as the S&P 500 are somewhat arbitrary in selecting companies for inclusion. But holding an index fund accountable to an independent benchmark has some value in terms of imposing discipline and consistency.
A few years ago, I spoke to the head of an ETF firm who was frustrated with the performance of one of his dividend funds, and he suggested that he might approach the index provider about tweaking the criteria. That’s fundamentally at odds with passive investing, and no self-respecting index provider would entertain such an idea. But a fund company that “self-indexes” may well consider it if its product lags its competitors in performance. I’m willing to pay a basis point or two in licensing fees to eliminate that risk.
Unless you believe that fund companies have become charities, they must at least be planning to use no-fee funds as a loss leader to bring on new clients whom they expect will buy other, more expensive products. That has always been the strategy of brokerages offering zero-commission trades on ETFs: They know many investors who sign on for that deal will get bored and start trading stocks as well, paying the normal commission for doing so.
As someone who has lobbied for lower investing costs for more than a decade, I want to jump for joy at the arrival of no-fee funds you can trade without commissions. And I applaud any move by financial firms to make investing easier for those of modest means, even if their motives are not entirely pure. I just hope investors will maintain a healthy skepticism and recognize that what stands in the way of investing success today is not just fees, but our own behaviour. That’s a burden from which humans will never be entirely free.
Dan Bortolotti, CFP, CIM, is an associate portfolio manager at PWL Capital in Toronto. He is the creator of Canadian Couch Potato, an award-winning blog about index investing.