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FREE! FREE! FREE!

Fidelity upped the ante earlier this week in the mutual fund price war by declaring that two of their index funds would carry zero cost for investors.

This goes to show that investors may have taken the pursuit of low cost to a ridiculous level. Considering the hundreds of funds that Fidelity manages for $Billions in annual fees, giving two funds away for free surely won't break the bank at Fidelity. As a matter of fact, one of the new "free" funds previously had a fee of 3/100 of 1% (.03%). That's $3 per year on $10,000, whoopee! I don't see Fidelity making a splash lowering their fees on their hundreds of other funds, some of which carry costs one-hundred times higher! They're hoping investors won't know the difference. This is likely since the majority of so-called no-load fund investors already believe (wrongly) that these funds were free to begin with. This is unlikely to change much. The scenario feels eerily similar to the old days of free toasters for buying a CD at a bank. The CD may offer an awful return, with awful tax characteristics on interest, buy hey, you got a free toaster.

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Segment has huge positions in dozens of "nearly free funds". So we're on board with low cost management. Yet, there is far more at stake in choosing a fund than simply how low the management fee is. Liquidity can drive far bigger considerations. This is because high trading volume (liquidity) drives down spreads. Spreads are simply another cost of doing business. This is akin to selling a car to Carmax, and they resell it for a$10 profit. Not likely. This is because they might sell only 20 cars a day. If they sold a million cars a day, they might actually make just $10 on each one. They actually make more like $1000 on each one today because cars are very illiquid. Similarly, a less-liquid index fund might have zero fees and could have spreads far greater than the savings in the new zero fee. It is also true that Carmax could advertise selling cars "at cost", and hope you show up and they "just sold the last one of those, how about this one?" It is also true Fidelity is a powerful marketer. This ploy can act as camouflage for a host of other higher cost funds, into which they hope an investor will swap. Clearly, they want to stop Vanguard, which has eaten Fidelity's lunch for years by offering funds with fees five-times cheaper than the average at Fidelity.

Surely Wall Street shudders at the word "free". Fidelity's announcement sent chills through the shares of BlackRock Inc. (BLK), the largest asset manager on the planet. Many Segment clients hold these shares since we like the asset managers as an investment. Yet BlackRock (the company, not the funds) lost $Billions in market value yesterday, though the index portion of their business is relatively small and likely not that vulnerable since they are already far cheaper than Fidelity across the board.

We looked at all of BlackRock's ETFs and they earn only $230 million annually in fund fees (before paying index providers and other expenses) from ETFs where they charge a fee of 0.10% and lower. These funds have a combined $415 Billion in assets. But they make $2.9 Billion in profits annually from ETFs that charge more than 0.10% and these ETFs have $992 Billion in assets. They could afford to cut fees on these low fee ETFs and still do well as long as they can keep their fees higher in their other ETFs. The same is true for Fidelity.

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BlackRock's iShares business is an original pioneer of the shift to low-cost ETFs and those assets tend to be "sticky". That's because ETFs have special tax treatment that allows larger deferred taxable gains to build up. Most investors are aware that sitting on those large profits compounds to better gains in a number of ways. Fidelity doesn't offer mutual funds with this special tax treatment since they offer only open-end funds. This seemingly small detail allows closed-end ETFs to build more than 90% of their gains tax deferred, while open-end funds must declare transactional profits each year on an investor's 1099. I have written about this many times, read more here. I sure hope investors don't bail out of their "nearly-free" funds with big gains to buy "free funds" and walk right into a much bigger tax buzz saw.

I grew up watching Daffy Duck cartoons. He always wanted to be "Rich!, Rich!, Rich!"; he would often propose getting there by getting stuff "Free!, Free!, Free!". He occasionally got scorched.

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