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Fidelity's Fee-Free Funds: What's the Catch?

By Jordan Wathen - Updated Aug 10, 2018 at 2:45PM

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Fidelity launched two index funds with zero fees. Here's how it hopes to make money doing it.

If someone wants to manage your money for free, you might reasonably fear that there's some hidden catch or fine print -- something that allows the manager to somehow shuffle money from your pocket to theirs. After all, finance has never been an industry that attracts people who enjoy working for free.

Yet Fidelity wants to turn mutual funds into charity work. Its new ZERO funds are index funds that offer an industry-leading expense ratio of exactly 0.00%. That is to say that Fidelity wants to work for you and charge you nothing for it.

What's the catch?

Rest assured that from my dive into the prospectus, everything seems to check out. These funds are essentially a loss leader -- the financial equivalent of a Black Friday doorbuster deal. Fidelity hopes you'll be enticed to open an account and use its other products and services on which it actually earns money.

The fine print for these two funds -- Fidelity ZERO Total Market Index Fund and Fidelity ZERO International Index Fund -- is pretty straightforward. The funds are only available to individual retail investors who reside in the United States and purchase shares through a Fidelity brokerage account. (Traditional, Roth, and SEP IRAs, HSAs, and stock plan services accounts all qualify.)

Basically, if you don't have a lot of money and don't manage money on behalf of others, you should be able to open an account with Fidelity and get access to its ZERO index funds. That's about as simple and as fair as financial fine print can be.

How Fidelity can make money with its ZERO mutual funds

Running one mutual fund is expensive. But it isn't that much more expensive to run 505 mutual funds instead of 504 mutual funds, especially if the 505th fund is an index fund. Fidelity, being one of the largest asset managers in the world with more than 69 million customer accounts, already has the infrastructure in place to handle another customer (or a million of them).

A third party, Geode Capital Management, which manages Fidelity's other index funds, will do the management work as the funds' sub-advisor. Geode will be compensated based on assets under management, collecting a fee of 0.0525% per year on assets in the international fund and 0.0125% on assets in the total market fund.

Fidelity will pick up the tab, of course, keeping with its promise of offering these funds with a 0% expense ratio. So if you drop $10,000 into the Fidelity ZERO International Index Fund, your proportion of the fees (all of $5.25 per year) will be paid out of Fidelity's pocket, not yours.

$5 bills wrapped in a rubber band

Image source: Getty Images.

The hope is that after opening an account with Fidelity -- or better yet, moving your million-dollar account to the brokerage -- you'll decide to place stock trades ($4.95 each) or put some of your money into its other mutual funds, which actually have management fees. If you keep any spare cash in your brokerage account, Fidelity will make money investing that cash and keeping most of the interest. Brokers make a lot of money on the spare cash you keep in your account -- it's one of the main ways the free brokerage service Robinhood makes money.

But even if you put all of your cash in its completely free funds, Fidelity can likely shave off a few dollars a year in revenue by lending out the stock the funds hold to short-sellers. Fund managers usually split so-called securities lending revenue with the funds' investors, sums that can easily rise into the tens of millions of dollars each year.

Does "free" really matter?

Realistically, these Fidelity funds will be the first to have a stated expense ratio of 0%, but they aren't the first to have an effective expense ratio of 0%. Last year, those who owned the iShares Russell 2000 ETF collectively paid about $78 million in expenses. But because many of the small-cap stocks the fund owns were loaned out to short-sellers, the fund earned $79.6 million in securities lending revenue, papering over all the costs of running the fund.

While that iShares ETF may have a stated expense ratio of 0.19% per year, the true cost of owning it was negative. Its investors, many of whom wouldn't otherwise bother with securities lending, basically got paid to own it. It's one of many ETFs and index funds that have a negative effective expense ratio.

But toss securities lending to the side for a second. More to the point, the real question is if a 0% expense ratio is really reason enough to move your money.

After all, Fidelity already has super-cheap funds that carry expense ratios of 0.015% per year, which amounts to $0.15 on every $1,000 invested. At 0.015% per year, you'd pay more for an ad-free Hulu membership than in management fees on $959,000 of investments.

If you're currently paying 1.5% per year in fund fees, you might have a good case that your overpaid fund manager might cause you to push back your retirement date. But with so many funds offering expense ratios of 0.10% or less, it's hard to argue that going from a low-cost fund to a no-cost fund will have any measurable impact on your financial life.

In short, these Fidelity funds have some fine print, none of which should concern you, but you shouldn't expect that a free fund is inherently that much better than any other low-cost index fund. The difference in index fund fees, frankly, has become a rounding error.

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