On Aug. 2, investment management giant Fidelity raised the bar for low-cost investing when it announced two new index funds with zero fees. Considering that the financial media has spent more than a decade lauding the benefits of low-cost index funds versus funds with higher fees, Fidelity didn't just raise the bar -- it may have changed the game.
Or did it? After all, it's not going to make any money from you on these funds, so what's the angle? In short, it's almost certain to bring in more new -- younger -- clients to build a financial relationship with and to make money with the many other services it offers. But the question for investors today is this: "Are these zero-fee funds a good deal or not?"
Let's take a closer look at what Fidelity is offering in these two new funds and how they stack up.
About the two zero-fee funds
First off, these are truly no-fee investment products, and they are designed to provide retail investors the lowest possible cost access to attain returns similar to the U.S. stock market with the Fidelity ZERO Total Market Index Fund and to international stocks with the Fidelity ZERO International Fund.
These funds have zero expense ratio, have no expenses for marketing, and when you buy directly from Fidelity, have no transaction fees. That's as low-cost as an investment gets. One of the ways Fidelity is able to offer a zero-fee fund is by creating its own indexes to track and not licensing a well-known index like the S&P 500.
In the case of the Total Market Index Fund, the company has developed the Fidelity U.S. Total Investable Market Index, "which is a float-adjusted market capitalization-weighted index designed to reflect the performance of the U.S. equity market, including large-, mid- and small-capitalization stocks."
The International Fund will track the Fidelity Global ex U.S. Index, also a proprietary Fidelity index described as "a float-adjusted market capitalization-weighted index designed to reflect the performance of non-U.S. large- and mid-cap stocks."
Fees matter, but so does performance
The historical performance of the U.S. stock market should make one thing clear: If the Total Market Index Fund does indeed produce similar returns to the market average over the long term, this fund should make for a great investment. There's also plenty to like about the International Fund, considering that a substantial amount of economic growth is happening outside of the U.S. today. There's an argument that international stocks could make for the better investment over the next 20 years or more than U.S. stocks.
But the underlying concern I have with both of these funds is that they are pegged to new indexes designed to act like existing indexes in order to lower fund costs, but investors need some evidence that returns will be similar to already super-cheap funds like the Vanguard Total Stock Market Index Fund (NASDAQMUTFUND:VTSMX), which costs investors about $1.40 per year per $1,000 invested in fees. The risk is the same for the International Fund, of course: performance against the market itself.
But if these funds generate market-level returns, eliminating even those small fees would be worth it. If you were to invest $1,000 per year in a zero-fee fund versus a fund with a 0.14% expense ratio from ages 30 to 65, you'd have an extra $12,000 simply by eliminating that tiny $1.40 per year per $1,000 in fees, based on stock market historical returns.
What's an investor to do? Don't rush into them just because of no fees
I'm sure the new indexes these funds are based on have been backtested and rigorously developed to mimic the returns of larger, more popular indexes, but to paraphrase a long-dead Prussian general, "no battle plan survives first contact with the enemy." In other words, until we have some evidence of performance from these funds, I think most investors would do just fine to continue investing in the existing low-cost funds out there. Furthermore, this first foray into no-fee funds will probably be followed by more options from competitors.
So I say wait. Retail investors have access to even cheaper ETFs like the Vanguard Total Stock Market ETF (NYSEMKT:VTI), with its 0.04% expense ratio (that's only $0.40 per year per $1,000 invested), so fees are becoming so minimal of a drag that it's worth giving Fidelity some time to prove that these funds can generate market-level returns and competitors a chance to step up.
But if these funds do prove to generate very similar returns to funds you're currently paying any fees for, it's hard to make an argument for not making the move.
Editor's note: A previous version of this article cited the Vanguard Total Stock Market Index Fund expense ratio as 0.014% (it is 0.14%) and omitted the time period over which the hypothetical portfolio was held. All other calculations were correct. The Fool regrets the errors.