Expenses Lowered to 10 Basis Points for Five Funds

Fidelity Investments cut the expenses on five of its equity index funds last week, slicing fees very close to the bone by capping its expense ratio at 10 basis points and making an obvious push into Vanguard's domain.

Several industry observers believe the move is an attempt by the Boston fund giant to hone in on Vanguard's reputation as the index leader and to take a crack at penetrating deeper into the index fund arena. The move will leave those Fidelity equity index funds at the extreme low end of the industry's range. These five funds will now be 88 basis points below the average equity index fund, which has an expense ratio of 0.98%, according to New York-based research firm Lipper.

Specifically, Fidelity slashed fees on the Spartan 500 Index, Spartan U.S. Equity Index, Spartan Total Market Index, Spartan Extended Market Index and the Spartan International Index funds, bringing expenses on all of them to a mere 0.10%. Fidelity has a total of nine index funds.

Fees on the $10.6 billion Spartan 500 Index and the $18 billion Spartan U.S. Equity Index funds, which both track the S&P 500, were trimmed only slightly, as both these Fidelity funds had already sported fees of 0.19%. But the decrease now positions them as less expensive than the $96 billion Vanguard 500 Index fund, which tracks the same index and charges 0.18%.

The decrease also gives Fidelity a more favorable comparison on fees for the $2.3 billion Spartan Total Market Index Fund. That fund previously had an expense ratio of 0.25% and now measures up well against the $45 billion Vanguard Total Stock Market Index fund, which charges 0.20%. Both funds track the Dow Jones Wilshire 5000 Composite Index

Fees for the $1 billion Spartan Extended Market Index Fund, which formerly charged 40 basis points, also now undercut Vanguard's $7.3 billion Extended Market Index Fund, which currently charges 26 basis points. Both funds track the Dow Jones Wilshire 4500 Completion Index. Lastly, the $602 million Spartan International Index Fund saw the greatest drop, as its fees fell 37 basis points from 0.47% to 0.10%. Vanguard's Developed Markets Index Fund charges 34 basis points. Both track the MSCI EAFE Index.

Max Rottersman, president of Fund Forensics of Hanover, N.H., formerly Fund Expenses, said the decision to lower expenses on those five funds will cost Fidelity $22 million a year, an amount he said that won't have a significant impact on the firm.

Fight to the 401(k) Finish

However, it is a direct attack on Vanguard's business and may end up steamrolling over other, smaller players in the index fund area, as well, Rottersman said. "This is all a fight over the lucrative 401(k) account business. Fidelity is taking off the gloves, and it's going to be a slugfest. I believe this is a phased process and the end result will have the funds being virtually free," Rottersman said, although at 10 basis points, he did acknowledge there is not a whole lot of wiggle room. "Fidelity is now making sure that potential clients never say their index funds are too expensive."

The largest fund shops - Fidelity, Vanguard and American Funds - can handily slash prices when they want, driving smaller players from the playing field, Rottersman noted. "Unless you are a big player, you can't compete. I don't see how anybody else is going to survive unless they have a close-knit, niche story. Prices matter. Niche funds will do alright, but everybody else that is middle of the road will get squashed," Rottersman said.

On a side note, Rottersman said that Vanguard may use the expense war as an excuse to take the company public in an IPO. He said that Fidelity and Vanguard are becoming more similar every day, with Vanguard adding more expensive funds, at the same time Fidelity keeps adding cheaper ones. "Fidelity has access to capital and Vanguard doesn't, so when there is a capital squeeze, Vanguard may claim that it needs to go public to raise more capital to compete," he said. Vanguard did not return calls seeking comment at press time.

Slim Margins

Vanguard is generally known for its index funds and low expense ratios, so Fidelity's fee decrease on its index funds is an obvious push to attract these customers. "Vanguard has built itself as a premier index provider," said Jeff Keil, vice president of Lipper's Fiduciary Review. "Cost is the primary driver of the index provider. Fidelity probably felt they were missing out on some of these flows."

However, charging a mere 10 basis points isn't going to turn these funds into a cash cow for Fidelity, but that is not the likely motive behind the move. Keil said that running an index fund costs the fund companies somewhere around seven to eight basis points. "At 10 basis points, that's pretty much bare bones. There's not much milk in there."

The real prize and main motivation behind the move may be in gaining market share from competitors, as well as selling other, more costly products, to index fund investors. An index fund is generally part of a larger portfolio, and Fidelity may want to have an attractive index fund to act as a building block for a full-fledged Fidelity portfolio. "In general, if you can get an investor in house, develop a relationship and establish a certain level of loyalty, you can sell other products to them," Keil said. The low ratios can also be used as a marketing tool. "Fidelity wants to be known as a one-stop shop and that includes a very competitive index product."

Rottersman estimates Fidelity is attracting about 15,000 new accounts a month, a figure he derived from Securities and Exchange Commission filings. When factoring in the $22 million yearly hit Fidelity is taking by lowering its fees, Rottersman says the firm is essentially capturing new accounts at $125 a pop.

The move to reduce fees to such a low level is not typical, but not surprising, either, according to Kunal Kapoor, director of fund analysis at Morningstar of Chicago. "The reality is that the index fund area has gotten more competitive. This is Fidelity's response to that reality. All things considered, if you are a fund shareholder, this is a pretty good deal."

For its part, Fidelity said the move was part of an ongoing effort over the last year and a half to cut expenses. "Fidelity now offers individual investors five diversified equity index funds that are among the lowest cost in the market," said Jeff Carney, president of Fidelity Personal Investments, in a statement. "It is the latest move in an aggressive effort over the past 18 months to scale back fees, expenses and commissions on a number of our products in order to ensure that we are positioning ourselves at the head of the pack in a very competitive marketplace."

In addition, Fidelity said it also standardized the required investment minimum across all of its retail equity index funds. Investors will be required to shell out a minimum of $10,000 for an initial investment in the fund and then $1,000 for each one after that. "As index funds are designed to perform in line with their stated benchmark indexes, we believe the best way to effectively compete in this area is on cost. And that's exactly what we're doing," Carney said.

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