Rekenthaler Report

Fidelity's Free Funds and the Changing Brokerage Business

John Rekenthaler

Ground Zero
Initially, I was confused by Fidelity's announcement last week that it launched two no-expense funds, Fidelity Zero Total Market Index (FZROX) and Fidelity Zero International Index (FZILX). No doubt, by offering costless funds, Fidelity will undermine its rivals. But that would seem to be a Pyrrhic victory. As the sage relates, nothing from nothing leaves nothing. There are no profits to be made from funds that collect no revenues.

(For another view of this announcement, see Jeff Ptak's article from last week, "Investing Crosses the Rubicon," which addresses the topic from another angle.)

Silly me. I thought of the Fidelity that was--the money manager that had long made its funds widely available, through any distributor that would take them. That Fidelity is no more. Today's Fidelity is a new-style brokerage, not a customary mutual fund firm. The purpose of the Zero funds is to bring customers in-house. Thus, the Zero funds are only to be found at Fidelity itself.

Selling Points
It is as if Fidelity runs an amusement park and has just eliminated the admission charge for its most-popular ride. Now, visitors can journey to FidelityLand, frequent only that attraction, and return home not one penny poorer. However, Fidelity thinks that won't happen. Those who spend the day at FidelityLand figure to score some snacks and hop on other rides. Perhaps they will buy a souvenir.

And FidelityLand generates revenues in several ways.

To start with the bad news: Commissions aren't what they once were, and it remains to be seen if customers will pay for digital advice, a version of which Schwab gives away. Happily for Fidelity, though, other fund companies will pay to be on Fidelity FundsNetwork, the company's No Transaction Fee program. Investors in FundsNetwork have 40 choices for parking their cash--all Fidelity money market funds. Those funds, unlike the Zero funds, don't work for free.

Plus, of course, Fidelity continues to run active mutual funds. Those will not tempt the purest of indexers. Most prospective Zero shareholders, however, will consider using active funds to "explore" the corners of their portfolios. From Fidelity's perspective, far better that index fundholders do that at FidelityLand, where they are surrounded by Fidelity investments, than at another park.

Old School
In some respects, this conjures up memories of traditional brokers like Dean Witter and Smith Barney, which also strove to get investors through the front door, and which also devised several paths to separate them from their wallets once they did. However, the comparison is superficial. The goals of Dean Witter 1988 and Fidelity 2018 were similar, but their sales propositions were not.

The full-service brokers were boutiques--companies that sold on the personal touch. What else could they do? Shearson, Lehman, and Hutton (three separate companies back in the day) each bought from the same financial markets, at the same prices. Those three firms, and their dozens of rivals, could only differentiate themselves by claiming better service.

In doing so, they created topnotch advertising campaigns. One featured a bull that plowed through the street; another a guy who made everybody stop and listen; a third the law professor from "The Paper Chase." Many of us remember those ads vividly, 40 years later. What we can't recall is how these companies were different--because they weren't. They hired the same people; trained them in the same fashion; and cross-pollinated by poaching. They were distinguished only by their labels.

(As my marketing professor once said about light beers, "When you run an advertising campaign on your new bottle, that's a pretty good indication that you taste just like your competitors.")

The full-service brokers attempted to change that in the 1980s by launching mutual funds. If service didn't bring in the business, then perhaps hawking proprietary funds would do the trick. "Come to PaineWebber. Only we have the IncomeVertible Fund." (There was indeed an IncomeVertible Fund, and only PaineWebber sold it.) That approach didn't work, either, because brokerage-house funds were pricey even by active management's standards, as well as prone to gimmickry.

Cheaper, Cheaper
Fidelity, to be sure, has just inaugurated two of its own proprietary funds. The context is quite different, however. The traditional brokers promoted quality. First, they claimed to have the best people, then the best-run mutual funds. They did not boast of having the lowest price. In contrast, Fidelity's Zero-fund tactic is based entirely on cost. The company makes no claim that its Zero funds are more skillfully run than any other index funds. They are better solely because they are cheaper.

The lesson seems clear to me: The investment-brokerage business has become about cost, not quality. This is not to say that today's brokers are worse than those of the past; I do not believe that to be so. Rather, it is that the leading brokers no longer claim to have the best people, or the best-run mutual funds. Instead, they position themselves on being thriftier than the next firm over.

The evolution of investment brokers, of course, is not limited to do-it-yourself investors. Financial advisors also require brokers, and financial advisors also seek access to the cheapest possible investments. Fidelity, Schwab, and Vanguard all seek those advisors' business, as do the full-service firms that traditionally have served them. It seems inevitable that pressure from financial advisors will continue to squeeze fund costs across all varieties of brokerages.

The lesson for investors: Consider the full picture. Index funds have never been a better deal, and will almost surely become better yet. That is indisputably a good thing. But, ultimately, no companies toil for free. What they give away in one place, they recoup in another. Savvy investors will understand where and how their broker turns a profit and will devise their strategies accordingly. If not, that "free" ride might end up costing a bundle.

For general guidance on whether differences in index-fund fees are worth switching brokerages, see Russ Kinnel's article from yesterday, "What Fidelity's No-Cost Index Funds Mean for Investors."

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.