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A Free Lunch?

Fidelity, the asset manager with $2.4 trillion assets under management, recently announced the launch of two index mutual funds with a 0% fee! This announcement is interesting for several reasons. First, the asset management industry has been involved in an intense price war and this new fee level of 0% represents a very tough benchmark for the competition to beat. Not surprisingly, the share price of rival asset managers fell by a few percentage points shortly after the announcement. Second, the new fee level is unusual as it indicates that, for the first time, investors could get exposure to both US and international equities without incurring any fee. This is a curious business decision. How will Fidelity manage to pay for all its expenses? Will this product be a loss-making venture? Is there more to it than meets the eyes?

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It is useful to remember that Fidelity is a full-service company that offers a wide range of services such as advisory, insurance, credit card and trading. In fact, Fidelity derives a substantial share of their revenues from non-index funds. The asset manager may very well not aim for the new index funds to be profitable. Instead, they could use these products to attract investors and then cross-sell other more profitable lines. Following this logic, the losses generated by the new products can be thought of as marketing expenses incurred to enable the asset manager to raise revenues from other (more lucrative) existing products.

Recent research by Evans et al (2017) shows that a growing number of mutual funds engage in security lending. Briefly, mutual funds that own securities, e.g. a stock, lend the securities to short-sellers who, in return, pay a lending fee to the asset owner. If done on a large scale, a mutual fund can, in theory, reap potentially large benefits from this activity. While security lending make a positive contribution to the income of a hypothetical mutual fund, it involves a trade-off. On the one hand, the fund can boost its income. On the other, it is helping out short-sellers who are betting against the fund investors. This may not be an ethically desirable outcome or something that an investor would be expecting as a side effect.

Evans, R., Ferreira, M.A. and Porras Prado, M., 2017. Fund Performance and Equity Lending: Why Lend What You Can Sell?. Review of Finance, 21(3), pp.1093-1121. Find out more about Dr Chardin Wese Simen's research.

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Dr Chao Yin

visiting fellow
Published 29th August 2018