By Michael McKeown, CFA, CPA - Chief Investment Officer
When something is free on the internet, it is because you are the product.
Facebook, Instagram, and Twitter are all “free” for users. Anyone using these sites and apps do not pay a fee for the privilege of using the platforms – not yet at least. Users pay by allowing the sites to take personal data, website searches, and more to sell to advertisers.
Last week, Fidelity announced that two of its mutual funds will have a zero percent expense ratio. This sent the media into a buzz and stocks of active fund managers fell.
The expense ratio is a powerful tool for predicting outperforming funds. Studies show that lower fee funds outperform higher fee funds.
Within low expense index funds, there are other ways managers make money. This includes lending out securities to other investors such as short sellers. Up to 33.3% of the portfolio can be on loan. The revenue from this activity is split among the fund shareholders and the fund company. According to a survey conducted by Morningstar, Schwab pays the lowest amount of revenue to third parties at 10% (the other 90% goes back to the fund shareholders). State Street of the SPDR funds pays lending fees of 15%, so shareholders keep 85%. Blackrock pays fees of 30%, so shareholders keep 70%. Fidelity did not respond to the survey.
“You get what you pay for.”
It is important to really look at the underlying index that a fund tracks. Two popular indexes investors follow within the U.S. small cap asset class are the Russell 2000 and the S&P 600. Many think the Russell 2000 might be better because of the greater diversification of owning more companies. The problem is that there are many unprofitable companies held in the index. In contrast, the S&P 600 is chosen by the Standard & Poor’s investment committee. The committee considers a company’s revenue and profitability prior to inclusion.
The performance disparity year to year varies, but over the long-term, the S&P 600 handily beats out the Russell 2000.
If you just picked based on expense ratio, you may find a fund tracking the Russell 2000 that is cheaper than one tracking the S&P 600. While expense ratio is important, it is not the only metric that should be used for fund due diligence.
Facebook’s stated mission “is to give people the power to build community and bring the world closer together.” It also has shareholders that want to see growing revenue and profits, which necessitates collecting data on users. It is not really free.
More fund companies will follow with zero fee expense ratio products. Remember if something online is free, you are the product. If something with your money is free, your money is the product. In this case, its being used to make money as a securities lender, disguised as a fund.
*Morningstar Manager Research, “Partnering With Passive Fund Sponsors That Have Your Back.” 18 October 2017
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