Are zero fee funds sustainable?

Fees on index mutual funds and Exchange Traded Funds (ETFs) have been steadily decreasing over the past decades as competition between asset management firms has intensified. However, Fidelity recently threw down the gauntlet by launching two funds with zero total expense ratios, no minimum investment amounts and no transaction costs if investors purchase them directly from Fidelity’s investor platform.

A few questions come to mind: What is the catch? Is this sustainable? How would they make profits using this strategy?

Loss leader strategy to attract investors

The oldest ETF, StateStreet‘s SPDR S&P 500, has been around since 1993 and is still the largest ETF at $270 billion (R3.9 trillion!). However, at a Total Expense Ratio (TER) of 0.09% it has not been the cheapest option available for some time as firms such as Vanguard and Charles Schwab offer their S&P 500 ETFs at 0.04% and 0.03%, respectively.

Enter Fidelity, who, like many traditional active asset management firms, has been feeling the pressure from the success of Vanguard who has taken the lion share of US net flows over the past few years.

According to Morningstar, Fidelity has lost over $180bn from their active funds since 2010. Their passive fund business makes up around $400bn of their total $2.5trillion[1] in assets under management. This is ten times smaller than Vanguard and iShares’s passive businesses. Therefore, Fidelity is likely using the zero fees funds as loss-leader products to retain some assets and hopefully attract new investors who may also use other higher-expense funds. The underlying costs incurred in the fund will likely be covered by revenue from securities lending. Fidelity also uses their own proprietary indices on these funds to save on index licencing fees, which could lead to inconsistencies with other competitor funds due to different index construction methodologies.

What are the risks when fees are too low to be sustainable?

For funds

Running funds at no profit can be a risky strategy, whether it be charging no fees (as in Fidelity’s case), or charging fees which are too low to be sustainable to attract new clients to build scale. It is important to understand that companies like Vanguard and iShares can charge low fees due to scale - and that they have been lowering their fees as their funds have grown larger.

The table below illustrates this by looking at the dollar fee earned on four different ETFs offered by iShares.

One can see how the largest ETF, the iShares Core S&P 500 ETF, can charge lower fees than the other three ETFs but still produce a sizable annual revenue of nearly R1 billion! This is of course only possible due to its massive size of around R2.4 trillion - a size which is around a third of the whole South African equity market[1]! We can, however, also see that as the fund sizes decrease, the TERs typically increase otherwise these products won’t be viable. The South Africa ETF has a TER of 0.62% which is more expensive than many ETFs available in SA .

For investors

There are risks to investors when funds become unprofitable as revenue will have to be recouped in one way or another if the asset management firm is to stay in business. Firstly, profits will have to be generated via other means which may result in less transparency across the whole value chain. For example, fees may be recouped through securities lending, brokerage and/or on bid-offer spreads.

Secondly, additional risk may be taken to enhance revenue through some of these alternative methods. This is often not understood by investors using the funds. Lastly, due to the low margin nature of passive businesses, and in some cases product complexity (too many different funds and investment vehicles), staffing on the ground may be thin which increases the likelihood of human errors in the management and administration of these funds.

Focusing on the Total Cost of Ownership (TCO)

Fees and explicit expenses are not the only consideration for investors, especially if they want to invest across different investment vehicles and tax jurisdictions. An equity index tracker funds typically aims to replicate its benchmark net of dividend withholding taxes but before all investments cost are taken into consideration. One would therefore expect the return delivered by an index tracker fund to be the benchmark’s return minus the Total Investment Charges (TIC).

However, the quality of implementation, the revenue created through securities lending and the application of double tax agreements will have a further impact on the performance relative to the benchmark. These additional factors will of course filter through in the funds’ performance and it is therefore advisable to compare different index funds after costs. Because the additional factors may include other risk it is preferable if they are also disclosed via a more comprehensive measure called the Total Cost of Ownership (TCO).

In the table below, we look at the TCO of the Nedgroup Investments Core Global Fund (A class) which is lower than its Total Investment Charge (TIC). This is because the underlying funds used in the Core Global fund generate additional returns of 0.03% though securities lending and saves investors around 0.12% in dividend withholding taxes. Dividend withholding tax differentials arise because double tax agreements between countries on income and dividends are applied at a fund level to some of the underlying funds - thereby saving the investor the hassle and costs of reclaiming the difference themselves. We would expect the Nedgroup Investments Core Global Fund’s performance to be the multi-asset composite benchmark’s return minus its TCO.

Improving the odds of achieving a funds return objective is clearly not as simple as picking the passive fund with the lowest TIC. The design of the fund needs to take implicit cost in implementation, risk and taxes into consideration. It is therefore better to look at the Total Cost of Ownership which filters into the long-term performance track record. Special care needs to be taken when fees offered on passive funds seem ‘too good to be true’ as there may be many hidden layers to make up for the unprofitable fees charged.

How low can fees go in the South African market?

The analysis in this article showed it is highly unlikely that passive funds in South Africa will reach the low TERs of their US counterparts. The South African market simply not big enough to achieve the same economies of scale which would allow for running funds profitable at the same fees. The question is: At what fee level can passive funds be run sustainable within the SA market?

We performed a back-of-the-envelope calculation to get a rough estimate of the weighted average net fees a hypothetical (pure) passive asset management firm (the ABC Index Fund Management), could charge across a diverse client base and still be profitable. We have assumed that this business has the same AUM and complexity as Coronation Asset management whose earnings are publicly disclosed.

It is important to note that most operating expenses in an asset management firm would be the same if they offer the same number products across the same number of different investment vehicles (unit trust, life pooled and segregated mandates) whether it follows an active or passive investment management style. By assuming that operating expenses could be reduced by 25% in a passive asset management firm due to fewer investments staff and bonuses, we can estimate a net fee on the total assets. At an average fee of approximately 0.25%, such a business will be able to deliver a profit after taxes as a standalone asset management firm. As a point of reference, Vanguard’s average net expense ratio across its assets of $5.1 trillion (ten times the size of the South Africa equity market) is 0.11%[3].

* Source: Coronation interim results presentation up to March 2018.

Therefore, this example implies that weighted average fees of lower than 0.25% will only be achieved in South Africa when passive businesses build substantial scale and can avoid unnecessary complexities to keep operating costs under control. Some further fee reduction may be recouped through securities lending. Success will also depend on being able to leverage off existing active management infrastructure and distribution networks.

[1] 31 March 2018

[2] Free float market capitalisation of the JSE All Share is R7.2 trillion as at 20 September 2018.

[3] Source Vanguard’s webpage. AUM as at 31 January 2018 which includes around $1 trillion of low cost active funds.