Race To The Bottom: Will The Price War Between Vanguard And Fidelity Lead To A 0.00% Expense Ratio Index Fund?

News came out in late July that Fidelity was again cutting expense ratios on their mutual funds. Vanguard responded emphatically in a conference call (emphasis mine):

As we continue to get scale, as we continue to grow and we get more efficient, we pass a large part of that back to our clients in the form of lower expenses. That’s not going to stop. If other people want to offer index funds, great. But you better be ready to keep lowering price, and we’re going to do it across every product.” – Tim Buckley, President and Incoming CEO, Vanguard

If it wasn’t already clear that there is a price war in index fund management, the latest salvos between Vanguard and Fidelity made it crystal clear.

The Index Fund Price Wars

All three major index fund managers (Vanguard, Fidelity, and Schwab) have slashed expense ratios in the past year. Vanguard cut rates in April 2017. Fidelity reduced expense ratios in 2016 and again in July 2017. Schwab cut rates earlier this year as well.

When I read that Schwab cut their rates back in February 2017, I cautioned readers against putting all their money into Schwab just because they currently had the lowest expense ratios:

“Schwab is continuing the price war between the major index fund managers. It was only three months ago that Fidelity lowered its rates and took out front-page ads…I suspect it won’t be too long until Vanguard lowers its rates as well.”

It took less than three months for Vanguard to cut their fees in response to Schwab’s own cuts.

Index funds are being treated as a commodity. We’ve been ingrained to focus on cutting fees, and investors are flocking to index funds and fleeing from actively-managed funds, including those at Fidelity.

This Has Happened Before

The rapid decrease in index fund expense ratios mirrors two other similar changes in the investment management industry over the past 30 years:

1. Commissions

It used to be that you had to pay $50-$100 to execute a trade with a broker over the phone. During the internet boom of the 1990s, startups like E-Trade and Ameritrade shook up the industry, offering stock trades for less than $10. Now everyone offers stock trading for less than $10. These days, Fidelity, Vanguard, and Schwab all offer commission-free ETFs.

2. Bid-ask spread

Years ago, it was routine for stocks be traded in fractions of a dollar. To buy a share of Microsoft, for example, the bid would be 37 1/4  and the ask would be 37 ½.

During one of my Wall Street internship interviews, I was peppered with rapid mental math questions, included stating the decimal versions of fractions such as 3/16 and 9/16. Knowing the decimal values of fractions was standard knowledge for traders many years ago. However, in the age of the Internet, bid-ask spreads have narrowed dramatically.

It used to be that typical bid-ask spreads would be 1/4 of a point, but that narrowed to 1/8 of a point, then 1/16 of a point, and 1/32. And then they decided to scratch fractions altogether. By 2001, stocks had completely shifted to trading in pennies instead of fractions.

Now, when you look at the bid-ask spreads of your favorite exchange-traded funds, the bid-ask spread is typically a penny, but the actual spread is probably even less than that. When I buy or sell ETFs, I use market orders, and I often get filled in between the bid-ask spread, even though the listed bid-ask spread when I get a quote is a penny (e.g. 109.81 bid and 109.82 ask for the trade below).

Current Expense Ratios at Vanguard, Fidelity, and Schwab

Here are the current expense ratios for the classic three-fund portfolio at Vanguard, Fidelity, and Schwab, as of July 30, 2018:

Could A Zero Expense Ratio Index Fund Be On The Horizon?

I am not sure whether we will ever see a zero expense ratio index fund. However, there is still some room for expense ratios to contract further.

Even though the lowest expense ratio available to retail investors at Fidelity is 0.035% for the Fidelity Total Stock Market – Premium Class, they are offering even lower expense ratios to institutional investors.

The Fidelity Total Market Index Fund – Institutional Premium Class, available only to large institutional investors such as companies with large 401(k) plans, charges only 0.015%. Some investors may be able to access this share class through their 401(k) plans.

Clearly, any zero expense ratio mutual fund would not be to make a profit. It would be a marketing strategy to get investors in the door.

I suspect that Fidelity and Schwab are already operating their index funds at razor-thin margins, or even as loss leaders to encourage investors to deposit their money with them. Some investors may need other services, such as cash management, donor-advised funds, or financial advice, and Vanguard or Fidelity stand to profit if investors choose to utilize those services.

In addition, Fidelity and Vanguard are aggressively trying to win business from corporations looking to offer low-cost 401(k)s to their employees. While the employees benefit by having rock-bottom expense ratios, the employers still have to pay some fees to Vanguard and Fidelity to administer their 401(k)s.

In spite of the contraction in their active management mutual fund business and the rapid decline in index fund expense ratios, Fidelity still is reporting record revenues and profits. They are doing something right and making more money than ever in this challenging business environment.

Whether or not we ever see a zero expense ratio mutual fund is inconsequential to the average investor. The difference between a 0.035% expense ratio at Fidelity and a 0.04% expense ratio at Vanguard is meaningless to the average investor. 0.005% on a $1 million portfolio is only $50.

At this point, you should pick your investment firm not based on cost, but on other factors like customer service and brand loyalty. Vanguard, Fidelity, and Schwab are all excellent companies and many investors pick a firm early in their career and stick with them.

What do you think? Does expense ratio still play a role in where you invest your money? Do you think there will ever be an index fund with a 0.00% expense ratio? If so, when will it happen?