Index tracking – past, present and future

 

I was interested to see that Fidelity has launched two new index funds in the US: Fidelity Zero Total Market Index Fund and the Fidelity Zero International Index Fund. Both have an expense ratio of 0.00%. As we know, Fidelity were late to the ETF and index fund explosion in the States and it looks like they are using their scale to accelerate their growth in this space and win their battle with BlackRock, Charles Schwab and Vanguard.

 

Scale is important and Fidelity is a huge international player with annual revenues of around $18bn. That is twice the revenues of the entire ETF market and four times the revenues of Vanguard. So even if this strategy is a loss leader they can afford to roll with it. This got me thinking about index funds generally; why they have experienced exponentially increased inflows over the past few years and what might happen next.

 

The story starts in 1976 with the launch of the Bogle-Lebaron First Index Fund which only achieved 10% of its $150m target. Unsurprising in retrospect; as it carried an 8.5% sales charge! Furthermore, it encountered tracking challenges resulting from a need to reduce costs and only sampling the smaller stocks in the S&P 500 as opposed to all them.

 

Renamed Vanguard Index, merged with another Vanguard fund and tracking the entire S&P 500, the fund started to gain traction. By 1987 it had reached $500m and other players had joined the market. Technology reduced trading costs, competition reduced expense rations and tracking errors were almost eliminated. But penetration in the UK was minimal. Why?

 

The reason that index funds did not take off swiftly in UK retail was very simple. They didn’t pay commission to advisers. This all changed with the emergence of Transact and others where fees could be taken from the platform. And it’s no coincidence that on some platforms index funds occupied the top slot in terms of flow. Index fund sales growth was then further fuelled by players such as Dimensional who were evangelists for the proposition and knew how to market it. Finally, of course, RDR and the complete removal of commission bias.

 

Of course, RDR was designed to provide complete transparency of adviser fees and the use of index funds reduced the overall charge to the client. Some people suggest that this might have contributed to increased sales. Others believe that many advisers just lost confidence in the value that active managers bring to the party. My guess is that it was a combination of both factors.

 

Most direct to consumer digital platforms now use index funds. I think that’s sensible; particularly if their target market is first time investors and/or consumers looking to make regular investments. Costs are low and the proposition simple. However, FTSE 100 is a blunt instrument. 40% of the index is in ten securities: Banks, drugs, fags, booze, energy and mining. I doubt most investors are aware of this. Actually; would they care? I think some might.

 

The reason I mention regular investors is that I think a portfolio comprised primarily of index funds is unlikely to be suitable for most clients looking for sustainable income. As I have said in the past, I think there must be scope for a “divestment” index which is not based on the size of companies’ market capital. For example; there are ETF’s based on dividend yield that might have a role to play. But in the meantime, active management seems a more sensible approach. And I was pleased to read that some recent Zurich research indicated that only 3% of drawdown portfolios are invested in index funds. Surprisingly, and perhaps alarmingly, 8% was “invested” in cash.

 

So where next? If index funds are a commodity then Fidelity could be on to a winner in terms of share in this increasingly popular space. But perhaps there is more to it than that. What about brand? What about service? What about stock lending strategy and governance? Are there trade-offs? I think there might be. After all, if a US adviser rates a manager highly in these areas and others, would they want to move client money from Schwab or Vanguard or BlackRock to save a few dollars. And it is just a few dollars. Schwab fees are 0.03. So, moving $10,000 to Fidelity would save just $30 a year. And there are other issues to consider: The cost of the adviser’s time and tax and tax wrapper implications to name just three.

 

More important; will Fidelity and others export their US pricing strategy to the UK market? And if so; how will it impact advisers and fund managers? Seems to me that it would be good news for the former and their clients, but a challenge for the latter. After all; why would you market a fund that costs you money? There may be a way to mitigate the loss and that might be the 0.02 or so revenues that might be generated by lending stock to short sellers. But are these revenues reinvested to the benefit of the investor? If so they might amount to more than the annual fees. Or are they retained by the fund manager?

 

If the revenues are retained by the fund manager; could we see the retail index fund market models turned on their head. I know it seems crazy at the moment; but if stock lending generates enough revenue for the fund manager then maybe the next step from zero charges might be paying investors to invest rather than charging them. And before you commit me to the asylum let us think about this. Might this be a cost-effective way for some fund manager D2C platforms to engage new customers and then, over time, sell them highly profitable propositions such as actively managed drawdown solutions?