Who's got the lowest cost index funds? Get your index fund expense ratio scorecard ready.

Last Tuesday, Fidelity Investments officially announced that the voluntary expense caps it had installed on four of its U.S. domestic index funds back in August would become permanent under a new contractual obligation.

The Boston behemoth agreed to hold fund expenses at 10 basis points for the Fidelity Spartan 500 Index Fund, the Fidelity Spartan Total Market Index Fund, the Fidelity Spartan Extended Market Index Fund and the Fidelity Spartan U.S. Equity Index Fund, primarily designed for 401(k) and 403(b) plans.

A fifth fund, Fidelity's VIP Index 500 Portfolio, which is used within annuities, is similarly capping expenses at 10 basis points, although this was not among the original funds for which Fidelity slashed expenses.

This contractual arrangement means there is no turning back for Fidelity. Should Fidelity wish to vanquish this 10 basis point expense cap and allow the fund to accrue and pay for its actual annual operating costs without subsidizing the funds, Fidelity would need not only a nod from the funds' board, but shareholder approval. No shareholder approval is required to reduce fees on a fund, only to increase them.

But the international market appears to be a bit trickier. Although Fidelity originally said it would also make the 10 basis point cap on the Spartan International Index Fund permanent, this fund, which saw the biggest cost differential drop from 47 basis points, will now jack its fees back up to 20 basis points.

Opportunistic Marketing Ploy'

Fidelity's price cut commitments come just two weeks after Vanguard CEO Jack Brennan had harsh words for Fidelity's original tack. Deriding it as an "opportunistic marketing ploy" in an online question and answer message to shareholders.

"Fee waivers are like a cents-off coupon," Brennan continued. "The couponing lasts for as long or short a period as the marketing folks think it's worth." Brennan further chastised Fidelity and other fee-waiving competitors for not really making a true commitment. "Low costs don't matter just for index funds. Low costs matter for every fund," he added.

That shot across the bow elicited a not so subtle response from Fidelity. "Despite questions raised by our competitors as to our commitment to low index fund fees, investors responded enthusiastically," said Jeff Carney, president, Fidelity Personal Investments, when announcing the permanent stance. He added that since the initial fund expense caps were installed, $2 billion has poured into the funds and, still, Fidelity would keep the fees at this very low level on this large sum of money.

Fidelity's primary but much smaller index fund that tracks the S&P 500 now has bragging rights to an expense ratio that is eight basis points lower than the longstanding 18 basis point expense ratio of the $104.1 billion Vanguard 500 Index Fund. Prior to the August expense ratio cut, the $12.2 billion Fidelity Spartan 500 Index Fund sported an expense ratio cap of 19 basis points.

Although Fidelity publicly responded to the Vanguard criticism last week, its decision to make those expense reductions permanent was not in response to the recent critique, said Fidelity spokesman John Brockelman. Fidelity had every intention of making those expense reductions long-term commitments and had begun the process of garnering approval to do that from the funds' board, he said.

"This action and the process was already underway prior to Mr. Brennan's comments," he said. However, Fidelity has no immediate plans to shave the expense ratios on other Fidelity index funds, he added.

E*Trade Becomes the Spoiler

While Vanguard and Fidelity may have traded insults, E*Trade Financial of Menlo Park, Calif., is hoping to undercut them both by capping the expense ratio on its proprietary E*Trade S&P 500 Index Fund at an even lower nine basis points.

In fact, E*Trade, which had been capping the expenses on each of its index funds, has been touting that its index funds are "still the lowest cost index funds in the industry." The lineup includes an S&P 500 index fund, a Russell 2000 index fund, an international index fund and a technology index fund.

"One of our main growth goals is to obtain assets under management and be the best value for serious investors with $50,000 to invest," confirmed an E*Trade company spokeswoman. "We really are aggressively going after assets," she added.

E*Trade only manages those four index funds and each of these is sub-advised by World Asset Management of Birmingham, Mich., a division of Munder Capital Management. Munder, in turn, is majority owned by Comerica Bank.

E*Trade Asset Management, the funds' advisor, has been subsidizing the index funds and will continue doing so, the spokeswoman noted. In a new red herring prospectus filed with the SEC on March 1, E*Trade disclosed that it has agreed to contractually cap the expenses on its four index funds through at least April 30, 2006.

For E*Trade, the index funds, with their ground-hugging expense ratios, may prove to be loss leaders that will pull investors into the firm's broader brokerage platform, said Don Cassidy, senior analyst with Lipper in Denver. It isn't just that Fidelity, Vanguard and E*Trade are competing with each other for expense-minded index fund investors, but also with the slew of assets flowing into exchange traded funds, he added.

ETFs have been the darling of the investment world, in 2004 capturing a sizable $55 billion in net new assets, according to the Investment Company Institute.

In the world of index funds, however, there hasn't exactly been a rush into S&P 500 index funds, as large-cap stocks have been underdogs in recent years. In 2004, S&P 500 index funds collectively amassed $11 billion, just more than the $10 billion they took in during 2003, Cassidy noted. Many of the S&P 500 index funds owe much of their gains to 401(k) participants who are on autopilot with their investments, he added. But if the tide starts to shift back to the large-cap sector, inflows could increase.

(c) 2005 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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