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What Fidelity's No-Cost Index Funds Mean for Investors

Fidelity sends a jolt to the asset-management industry.

Fidelity shook the investment landscape last week when it announced that it would offer two index funds with zero expense ratios: Fidelity Zero Total Market Index FZROX and Fidelity Zero International Index FZILX. And not months in the future, but right away--they went live on Friday! Also striking is that Fidelity removed investment minimums.

I have a couple of thoughts on why Fidelity would do this and what it means for investors. I'll start with the industry view first.

Loss Leaders Schwab and Fidelity can afford to offer index funds below their cost because they will make it up with all the other funds and brokerage services that clients will buy. Fidelity has a unique position in the industry in that it is a big player in brokerage, 401(k)s, and both actively and passively managed funds. In addition, Fidelity has always wanted to be the biggest and best. Other parts of the business remain quite profitable. In fact, Schwab and Fidelity have been pushing costs higher in their No Transaction Fee networks by charging fund companies--not investors--ever more to be on their platforms. Thus, I would guess Schwab will follow suit with its own fee cut.

But for Vanguard and BlackRock, where indexing is the core of their business, zero-fee index funds are much trickier. You don't want to run the core of your business at a loss. Vanguard would be particularly challenged to do this given that it aims to charge expense ratios at cost across the board. If it subsidizes one fund, where does Vanguard make up for it? And how does it rationalize giving a better deal to one group of shareholders than another? My guess is that Vanguard will have a more muted response, but it will certainly feel pressure to drive fees lower. And it will still be the lowest-cost provider in the aggregate.

What Does This Mean for Investors? There are three clear beneficiaries of Fidelity's free index funds.

1) People already in Fidelity index funds. Fidelity is cutting costs across a wide array of its index funds by 35% on an asset-weighted basis, and it is collapsing them into the cheapest share class. Fidelity said the fee cuts have already gone into effect, so shareholders don't have to take any action.

2) Investors with Fidelity accounts who want to lower their overall costs. If you have an account with Fidelity but don't have index funds, you can add one or both and lower your costs. I wouldn't worry that much about overlap if you already have large-cap funds. I would worry about taxes, though, so if you are in a taxable account, be mindful of the potential tax implications for selling any existing holdings to move into these funds.

3) Younger investors still building their portfolios. Sometimes investors start out by buying the exciting stuff and leaving their core a little neglected. Well, here's your chance. You can build up your core with the no-cost and low-cost index funds. And with no minimums at Fidelity, you really don't have an excuse.

If you don't have a Fidelity account and you are happy where you are, it probably doesn't make sense to move. If you already own some very low-cost index funds, you may well get a fee cut in the near future for reasons I've outlined. Also, a few basis points are big news, but they won't have a huge impact on your bottom line. Chances are you'll see some benefits just by staying pat. In addition, the taxes on selling holdings in a taxable account could well be greater than any cost savings.

To illustrate the modest stakes for your portfolio, let's look at the growth of a $10,000 investment in

In the bigger picture, as my colleague Jeff Ptak pointed out last week, costs are coming down across the investment landscape. Just as you should review your portfolio and your goals on a yearly basis, it makes sense to see if there are some major cost savings available to you that weren't there before. And you'll want to look at all the costs, not just those of the cheapest index funds.

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