How to Get Paid for Investing in ETFs

August 1, 2018…

A date that will go down in infamy in the investment management industry.

A shocking announcement from mutual fund giant Fidelity Investments hit the industry like a bombshell…

And sent the share prices of the world’s top publicly traded money managers plummeting.

Shares in BlackRock, the world’s biggest asset manager, fell by 4.6%.

Franklin Resources tumbled 5.5%. Invesco dipped 4.3%.

So just what was this shocking news?

Fidelity announced the advent of zero-fee index investing.

Specifically, it launched two new stock index mutual funds: The Fidelity ZERO Total Market Index Fund (FZROX) and the Fidelity ZERO International Index Fund (FZILX).

The management fees on each of these products?

A whopping 0% per annum. (Yes, you read that right.)

Fidelity’s announcement means that you can gain exposure to almost every stock in the world… for free!

The Bad Old Days of High Fund Fees

Fidelity also announced it was cutting the fees of its existing stock and bond index funds by an average of 35%.

That move alone puts an extra $47 million in investors’ pockets each year.

How things have changed…

Back in the late ’90s, I wore two hats as a portfolio manager.

First, I had to manage a slew of European, Canadian and U.S. mutual funds.

Second, I had to regularly pitch my U.S. funds to retail brokers across the United States.

Whether I was visiting brokers in Atlanta, Kansas City or Baton Rouge, I found that they had two things in common.

First, they played a lot of golf.

Second, they humble-bragged about their new pools and the latest additions to their McMansions.

Frankly, I couldn’t figure out how a pretty average group of guys was making so much money.

Now I know.

The class of mutual fund shares I was pitching charged a front-end sales load of 4.75%. (Legally, it could have been as high as 5.75%.)

That meant that an investor who put $10,000 into my fund paid a sales commission of $475.

And that amount went straight into the broker’s pocket.

If a broker convinced his client to invest $1 million into a fund… voila! He’d put close to $50,000 toward his new Minnesota lake house.

And this was in addition to the 1.5% annual management fee for the investor on the fund itself. (That’s how we lowly portfolio managers made our money.)

The whole arrangement struck me as kind of a scam.

But, hey, it was a bull market… and everyone was making money.

Today, front-end loads on mutual funds are much less frequent. But egregious management fees for certain funds are still around.

The biggest fee offender? The Rydex S&P 500 Fund Class C (RYSYX).

This generic index fund charges an outrageous 2.31% in fees each year – close to $5 million a year.

Compare that with the Vanguard 500 Index Fund (VFIAX), which charges a mere 0.05% per year.

That’s an astonishing 46-fold difference.

“Free” ETFs Are Already Here

Fidelity’s zero-fee mutual funds have shaken the index fund industry to its core.

As a result, I expect two things to happen.

First, I predict that a sustainable zero-fee exchange-traded fund (ETF) will be offered within the next year.

The innovative ETF industry won’t be willing to play second fiddle to stodgy index funds for long.

Besides, zero-fee ETFs aren’t a massive leap of faith from where we are today.

Some ETF providers already charge annual fees as low as 0.03% on U.S. market index ETFs.

That’s a tiny $3 on a $10,000 investment.

Second, I expect that some ETFs will market themselves as actually paying you to own them.

If you think this is an outrageous prediction… consider that there are a handful of ETFs that already do this.

The Schwab U.S. Small Cap ETF (NYSE: SCHA) has a 10-year cost of ownership, per $10,000 invested, of negative $61.

The Vanguard FTSE All-World ex-U.S. Small Cap ETF (NYSE: VSS) has a 10-year cost per $10,000 of negative $223.

How is this possible?

It turns out that ETFs can generate revenue by charging fees on the shares they lend out to borrowers who want to short individual stocks.

This additional source of revenue makes “negative-fee ETFs” possible.

Why does this make business sense?

By offering zero-fee index mutual funds and ETFs, Fidelity is hoping to bring more customers through the door.

It can then charge fees for specialty investment products and other services over the course of a (hopefully) 30- to 40-year relationship.

Fidelity has thrown down the gauntlet with its zero-fee index funds.

We’ll see whether it’s Vanguard, Schwab or BlackRock that follows suit.

Good investing,

Nicholas