The story behind cuts in index fees

Your Funds

Your Money

September 19, 2004|By CHARLES JAFFE

A LOT of people got excited when Fidelity Investments announced recently that it was cutting fees on five index mutual funds.

You heard talk about price wars with the Vanguard Group, of a new "low-cost leader" in fund investing and more.

But the real story is not so much about the change in cost structures as it is about investment strategies and opportunities. For die-hard index fund investors, the good news has more to do with tax benefits than lower costs.

Fidelity announced that it was putting a fee waiver on its Spartan 500 Index, Spartan U.S. Equity Index, Spartan Total Market Index, Spartan Extended Market Index and Spartan International Index funds. The move drops the annual costs on those funds to 0.1 percent, down from between 0.19 percent and 0.47 percent.

Vanguard charges 0.18 percent for its flagship 500 Index fund, so Fidelity's cuts make it the industry's new price leader.

(Online brokerage firm E*Trade followed Fidelity's move by dropping costs on its S&P 500 and International Index funds to 0.09 percent. Technically, that earns the distinction of "lowest-cost operator," but E*Trade is a flea in the fund world while Fido is the big dog.)

While the media played up the war with Vanguard, Fidelity's real target may have been exchange-traded funds. ETFs are built like index funds but trade like stocks, and they have been growing in popularity largely because of a bargain-basement pricing structure. The two biggest ETFs tracking the Standard & Poor's 500 have expense ratios of 0.09 percent and 0.12 percent.

One downside to ETFs is that, like stocks, they have transaction costs, with brokerage commissions coming on top of the expense ratio.

At 0.10 percent and with no commissions, Fidelity pretty much kills any cost advantage ETFs had on its funds.

Says Russel Kinnel, director of fund research at Morningstar Inc.: "This may be an effort on Fidelity's part to make sure fund investors never get too familiar with ETFs. If so, it works, because this pretty much kills the chance for an ETF to be better than Fidelity's fund for a long-term investor."

Fidelity effectively boxed out Vanguard, too.

Vanguard officials have long maintained that the firm's biggest index funds have been priced "at cost," and that they had no intention of turning their bread-and-butter products into "loss leaders." If Vanguard cuts costs to respond to Fidelity, it either takes a loss on indexing or it was kidding when it said prices were as low as possible; expect Vanguard's response to be no reply at all.

Truth be told, Vanguard doesn't need to do much to combat Fidelity here. A difference of 0.08 percent in expenses amounts to a difference of $8 per year in costs for every $10,000 invested. That might be enough to sway an investor picking an index fund for the first time, but it's hardly going to make a Vanguard die-hard bolt Vanguard for Fido.

What's more, Fidelity has used fee waivers before, and some observers worry that the company is again using cost reductions as a temporary enticement, hoping that inertia will keep investors in place when the price of indexing goes up.

Today's index investors likely have forgotten that Fidelity put a fee waiver on index funds in 1990, trying to capture a growing share of the indexing world. Investors responded, Fidelity's assets under management grew, and the firm nearly doubled expenses over the next four years.

By waiving fees rather than declaring an outright reduction, Fidelity retained an out for raising costs at will - and gave critics some ammunition - but company insiders suggest the firm is making a strategic attack on the indexing business and that there is nothing temporary about these price reductions.

For consumers, it doesn't matter much. Investors don't care about Fidelity's motives as much as they want their own bottom line to be improved; the cuts will help, even if Fidelity someday inches costs higher again.

And while the cost savings are so minimal that few experts suggest making a change to the new low-cost leaders, the real strategy involves changing funds for tax reasons.

Investors who bought into an S&P 500 index fund at the peak of the bull market are still down on that money. They can unload their current index fund - or just their highest-priced shares -- and move into a similar fund with lower costs as a bonus.

"There are a lot of people in index funds who have losses - at least on money they invested in 1999 and 2000 when index funds had their biggest in-flows - and this gives them a chance to get the tax benefits of the loss and lower their costs at the same time," says Dan Wiener, editor of the Independent Adviser for Vanguard Investors. "That's the real opportunity here."

Chuck Jaffe is senior columnist for CBS MarketWatch. He can be reached at or Box 70, Cohasset, MA 02025-0070.

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