It appears as if the era of ‘no cost’ investments may be upon us. Fidelity has announced that they are launching several no-load Fidelity ZEROsm index funds which have no annual operating expenses.1 Although Schultz Collins [SC] welcomes this development, it may be a bit premature to buy these funds.
Consider, for example, the Fidelity ZEROsm International Index Fund. As a general rule, SC requires a track record sufficiently long for statistical and econometric testing. For example, a “simple” test verifies that a fund achieves returns that closely track those of its benchmark index. This is especially important for funds that use “sampling techniques” (the Fidelity fund employs a representative sampling method) as opposed to funds that own all securities within an index.
The fund’s prospectus describes its investment objective as follows:
The fund seeks to provide investment results that correspond to the total return of foreign developed and emerging stock markets.
Sounds good! However, the investor next learns that the return is defined in terms of Fidelity’s proprietary index: The Fidelity Global ex U.S. Index. Without going into mind-numbing detail, the underlying index is subject to manipulations designed to make it easier for the fund to track it.
The fund’s investment adviser is an affiliate of Fidelity Management & Research Company. The fund also employs Geode Capital Management as a sub-adviser. It is possible that Fidelity elects not to categorize payments to Geode as operating expenses.
How does the fund make money? The answer(s) to this question are somewhat opaque. Fund families often define “operating expenses” differently. This might lead a cynic to conclude that a zero-expense fund may simply be a fund that shifts expenses into accounting buckets that lie just outside of “operating” categorizations. Although we have no evidence that this is what Fidelity intends, we are not aware that capital markets have suspended the “no-free-lunch” principle.
Additionally, the fund generates income through securities lending activities.2 Often a prospectus contains wording like: “the fund is authorized to loan up to x% of fund assets.” The Fidelity prospectus does not place a cap on its securities lending activities. Here is how it describes securities lending risk:
Securities lending involves the risk that the borrower may fail to return the securities loaned in a timely manner or at all. If the borrower defaults on its obligation to return the securities loaned because of insolvency or other reasons, a fund could experience delays and costs in recovering the securities loaned or in gaining access to the collateral. These delays and costs could be greater for foreign securities. If a fund is not able to recover the securities loaned, the fund may sell the collateral and purchase a replacement investment in the market. The value of the collateral could decrease below the value of the replacement investment by the time the replacement investment is purchased.
What is most interesting, however, is the fund’s policy with respect to use of derivative financial instruments. Fund families such as Vanguard use these instruments not for speculative purposes, but rather, for cash management. By contrast, Fidelity states:
Geode may also use various techniques, such as buying and selling futures contracts, swaps, and exchange traded funds, to increase or decrease the fund’s exposure to changing security prices or other factors that affect security values.
We find it troubling that an index fund tracks a proprietary index; and, that that it can use derivative instruments in ways that sound suspiciously like it’s trying to beat the index.
SC acts as a fiduciary within the scope of its advisory engagements. We feel that our independent testing and monitoring of individual investments is one of our most important client services. We read and evaluate a fund’s prospectus so you don’t have to.
SC is delighted to see the cost of fund ownership dropping. We will watch the new Fidelity Index funds; but, at this time we are not motivated to recommend them.
Note that every fund incurs expenses not included in the annual operating expense ratio. These are primarily, although my no means exclusively, transaction costs for buying and selling securities.
This is a common practice among virtually all fund families.