Over the weekend, The Wall Street Journal reported that Fidelity is taking an unusual step to impose a surcharge when retirement savers use a Fidelity-administered 401(k) to invest in a Vanguard fund. Fidelity will "charge some new corporate customers that hire the firm to run their 401(k) plans a fee of 0.05% on assets invested in Vanguard funds," according to the WSJ's reporting.
A Fidelity spokesperson told the WSJ that the change is "about leveling the playing field." That may be a stretch. The move effectively makes Fidelity's index funds less expensive than Vanguard's funds, based on my analysis of expense ratios detailed on each asset manager's website, though pricing differs by share class.
The modern mutual fund landscape
As investors increasingly turn to index funds rather than actively managed funds for their retirement wealth, fund managers like Vanguard are taking in the lion's share of fund flows. After crossing $2 trillion in assets under management (AUM) in 2013, Vanguard reported that it had $4.5 billion of global AUM as recently as Sept. 30, 2017.
Vanguard isn't just one of the world's largest asset managers; it's also one of the fastest-growing, a reality that worries fund managers who rely on higher-priced actively managed funds and 401(k) plan assets to pad their bottom lines. Retirement plans are one place where funds don't compete on a level playing field. Though there are thousands of mutual funds in existence, a study by BrightScope found that the typical 401(k) plan offered less than 30 fund choices.
Retirement plans are a honey pot for generating sticky assets on which asset managers can levy an above-average fee. That's because every time a retirement plan saver gets a paycheck, an asset manager gets a handful of cash flowing into their funds. Once invested, the money is less likely to flee, as 401(k) participants are less likely to move their assets than other investors.
Few have been as successful as T. Rowe Price (NASDAQ:TROW) in courting 401(k) plans and their administrators. The asset manager's wildly popular target-date funds and trusts were responsible for $223 billion of its AUM as of Sept. 30, 2017, up from less than $60 billion at the end of 2010.
In percentage terms, target-date products make up roughly 24% of T. Rowe Price's assets under management, twice the percentage at the end of 2010, largely driven by 401(k) wins. (To be sure, T. Rowe Price's target-date funds are performing well, often ranking as the best of the bunch in terms of historical performance, though higher fees on target-date funds raise the bar for market-beating performance over the long haul.)
Fidelity's surcharge won't affect savers directly, as the cost is charged to the employer, not the employee. Of course, expenses are fungible, and the cost could be made up in other ways, perhaps by reducing employer matches or making other changes to 401(k) plans to favor funds that pass on more of the cost to employees.
The administrative costs of running a 401(k) plan are routinely passed on to savers. This is evidenced by the fact that smaller companies typically offer more expensive funds in their 401(k)s, which helps defray the higher per-employee expense of administering the plan. (The cost of running a plan does not scale directly with the number of participants or assets, so larger plans are proportionally less expensive to administer.)
A study by BrightScope found that stock funds in 401(k)s with fewer than 100 participants carried average expense ratios that were roughly 50% higher than plans with 5,000 to 9,999 participants. The differential was larger in percentage terms for index funds, where sub-100 participant plans offered index funds with an average expense ratio of 0.17% vs. 0.10% for plans with 5,000 to 9,999 participants.
Creating its own demand
Vanguard doesn't operate like most asset management firms. It has no profit motive, as it doesn't have any outside shareholders to serve. (Vanguard's clients own the company.) For this reason, the fund manager seeks to keep operating expenses low in a bid to attract cost-conscious clients.
As a result, Vanguard funds are often prohibitively expensive to buy through online discount brokers like Charles Schwab (NYSE:SCHW), TD Ameritrade (NASDAQ:AMTD), Fidelity, and E*Trade (NASDAQ:ETFC), none of which offer its mutual funds or ETFs in a transaction-fee-free form. In contrast, many fund managers pay fees to brokerage firms who bring them clients and assets under management, indirectly passing on the cost to investors in the form of higher fund fees.
Distribution is a big business for companies that control the platforms on which self-directed investors pick their own funds. Charles Schwab's clients had an average of $215 billion invested in "Mutual Fund OneSource and other non-transaction fee funds" on its platform last year, booking fees equal to 0.33% of average client assets. It also generated an average fee of 0.09% on assets in "other third-party mutual funds and ETFs" last year, which subsidizes the cost of offering commission-free ETF trades. In all, these fees generated $957 million of revenue for the brokerage in 2017.
Others are eager to replicate Schwab's success. TD Ameritrade now charges ETF issuers a fee to have their funds on its commission-free ETF platform. TD Ameritrade's list of commission-free ETFs previously included several of the most popular Vanguard ETFs, all of which were axed when the list was overhauled late last year.
Since the largest index funds often carry a net expense ratio of 0.10% or less, they simply can't afford to pay for distribution unless they raise fees on all of their investors. Vanguard eschews the practice of paying for distribution, preferring to keep costs low. So far, the model is working, as the fund company frequently ranks among the top of the pack for investor inflows, proving that investors want low fee funds, even if they have to go out of their way to get them.