The new era of zero

How will the advent of zero-fee funds change the investing status quo for investors and firms alike? The past decade has seen seismic shifts in the investment landscape, and now, with the introduction of the first index funds offered to retail investors at no cost, new waves of change have arrived on the horizon. For retail investors, the emergence of zero-fee index funds, alongside brokerages that allow clients to trade at no cost, means the price of capital market participation is shrinking. For investment firms, the coming challenge will be to find new and innovative ways to maintain revenues and market share as charges to clients continue to trend down.

The first to cross the no-cost threshold

In August 2018, global multinational financial services company Fidelity announced "Fidelity Zero," a new product offering exposure to global index funds with no management fees. While Fidelity was the first market participant to cross the zero-cost threshold, the pathway to zero has been paved by multiple competitors who have long competed on price.

Owing to their relatively low cost, convenience, and transparency for investors, the investment market share occupied by passive index funds and exchange-traded funds (ETFs) has grown dramatically over the last decade, by 528 percent.¹ As ETFs in particular have grown in popularity, competition among providers has heated up, with price wars one notable result. While no other brokerages have moved to fee-free funds, the passive ETFs offered by Vanguard and BlackRock cost only a few basis points more than Fidelity's new offerings.

Investor costs fall as providers move to commission-free trades

The five largest ETF providers in the US today—BlackRock, Vanguard, State Street, Invesco, and Charles Schwab—control nearly 90 percent of the market, with the top three owning a combined market share of 82 percent in the US and more than 70 percent of all ETF assets globally.²

While Fidelity's new fee-free fund is one outcome of the provider price wars, another is commission-free trading. Vanguard, which has trained its focus on low fees since the firm's founding in 1975, announced in August 2018 it was eliminating all ETF trading costs for investors using its brokerage platform. This replaces the company's previous offering in which limited free trades were available only to investors with at least USD 1 million in a brokerage account. With the announcement, Vanguard's brokerage clients can now trade in excess of 1,800 ETFs without commissions as the company strives to win business away from its rivals.³

In addition to reduced costs, firms are expanding their overall suite of offerings and finetuning interactions with customers

While Vanguard is the first to offer completely free trading, other firms offer more limited no-cost options. For example, Schwab allows customers to trade more than 200 ETFs without charging commissions, and Fidelity offers iShares from its preferred provider BlackRock at no cost.⁴

Stock pickers under pressure as dollars glide from active to passive

The move to no-cost trading and fee-free products also takes place as investor dollars flow towards passive investment options and away from traditional active management. 2017 data from Morningstar Inc. shows that investors have generally been maintaining their positions in US equities, but switching from high-cost active to low-cost passive choices. The same data shows that active US equity flows have been negative since 2006, while ETFs have continued to grow in popularity.⁵

As their fees are lower, passive funds are much less profitable for the manufacturers than active funds, meaning money management companies have focused on claiming and retaining market share as the move to passive intensifies. Analysts speculate that the search for market share has prompted the arrival of ultra-low-cost and now, no-cost product offerings. "We continue to see these broader fee pressure trends persisting as competition for client assets intensifies," commented Morgan Stanley analysts after the Fidelity zero-fee funds were announced.⁶ "The discount brokers need to draw more newbies into the fold," noted Mitch Goldberg, president of investment advisory firm ClientFirst Strategy, "So this is the new bait."⁷

Low- and no-cost funds as loss leaders

Although index funds, ETFs, and traditional active mutual funds are different products, they face the same growing price pressures as the trend to lower costs across the entire investment industry gains momentum.

Attracting new customers with low-cost and free products as loss leaders is the most plausible economic rationale for Fidelity's move to a free product offering. Analyst Adam Grealish commented that it's "like lowering the cost of your airplane tickets but charging more for carry-on luggage."⁸

In addition to reduced costs, firms are expanding their overall suite of offerings and fine- tuning interactions with customers—such as simplifying the way clients are charged for advice, implementing securities lending programs, and leveraging digital technologies to build more engaging client experiences.

As ETFs have grown in popularity, competition among providers has heated up, with price wars one notable result

At the same time, some elements of asset managers' product suites are less attuned to price competition. At BlackRock, for example, offerings include low-fee funds that compete with rivals such as Fidelity and Vanguard, as well as a group of more expensive funds, geared towards institutional traders, which generate the majority of ETF revenue for the company. The market for these funds is less price-sensitive than funds aimed at retail investors.⁹

Fintech threatens further disruption

All of the established ETF players also face pressure from venture capital funded start- ups, such as Robinhood, which offers a free brokerage trading app.

In February 2018, Robinhood announced it would offer no-commission cryptocurrency trading in several US states, including California. The company sees giving away the service for free as a play to gain users for its existing service offering (which already allows people to trade stocks, ETFs, and options without additional charges). Wealthsimple in Canada announced a similar offering in 2018 and accumulated over 40,000 signups for their waitlist, which represents a significant bump to their previous customer base of 100,000 users.

While investing costs are the biggest factor for investors, they are not the only factor. As the battle for market share continues, providers will need to find ways to retain and build customer loyalty through other features and offerings—from digital-enabled advisory services to securities lending to cross-selling strategies.