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Fees Migrate From Asset Pickers to Asset Allocators

While fee cuts are heralded as boons for investors, there's no guarantee that those savings will wind up in their pockets.

By Nir Kaissar

(Bloomberg Gadfly) --It’s a stunning turn. Fidelity Investments -- the mutual fund powerhouse that made its name and fortune on high-priced active management -- now charges less for its own stable of index funds than the Vanguard Group.

Fidelity boasted in a press release on Monday that “100% of Fidelity's stock and bond index mutual funds and sector ETFs will have total net expenses lower than their comparable Vanguard fund.”

The move prodded Vanguard into a turn of its own. Vanguard has rightly argued for four decades that, “The less you pay for your funds, the more you keep in your pocket -- it’s that simple.” In response to Fidelity’s announcement, however, Vanguard spokesman John Woerth acknowledged that there’s more to consider than just fees, such as “how closely the fund tracks its index and after-tax returns.”

The discussion around fees is an important one, but it misses the bigger picture. Fidelity’s announcement was roundly applauded as a boon to investors. According to Fidelity, the move will save investors roughly $18 million. It’s not clear, however, that those savings will end up in investors’ pockets. It’s more likely that what investors save in fund fees, they’ll more than pay elsewhere.       

Let me explain. For decades, public markets offered U.S. investors two types of investments, or asset classes: U.S. large-cap stocks and high-quality bonds. With just two assets, investors didn’t have to fuss with asset allocation. Instead, the challenge was picking individual stocks and bonds. Most investors, of course, weren’t stock pickers or bond managers, so they paid fund managers to create ready-made stock and bond portfolios.

Everything began to change in the 1970s. In no order of importance, four developments eventually upended the fund industry and changed the way that portfolios are constructed.

The first was Vanguard’s introduction of the index fund in 1976. Vanguard’s S&P 500 fund proved over time that a low-cost index fund beats the vast majority of active managers.

Second, overseas markets opened to U.S. investors. It started with stocks in developed markets outside the U.S. Then emerging-market stocks became accessible. Government and corporate bonds followed. Tens of thousands of publicly traded stocks and bonds around the world are now available to U.S. investors.

Third, academic researchers developed systematic methods -- or factors -- that explain historical returns from stocks and bonds, such as value, size, momentum and quality. It turns out that those factors can also explain why an active manager beat or lagged the broader market.

The fourth development was the democratization of financial data. What used to be the exclusive domain of elite financial institutions became available to just about everyone.

The convergence of those developments -- indexing, global and factor investing, and the availability of data around it all -- opened the doors to easy and endless variations of new asset classes. What followed was an explosion of indexes and index mutual funds and ETFs that track them. According to data compiled by Bloomberg Intelligence, there are now more indexes than U.S. stocks.

Ironically, the proliferation of index funds has made investing more complicated, not less. Gone are the days of the two-asset portfolio. The challenge now facing investors is how to construct a portfolio from the huge variety of country, sector and factor index funds.

It’s no wonder, therefore, that the cost of index funds -- and single-asset-class funds generally -- is declining. There’s only so much that investors are willing to pay money managers, particularly in this era of fee compression. And the fees that investors once paid fund managers are increasingly going to asset allocators.  

Granted, some investors are savvy enough to construct their own portfolios of index funds, and for them the cost savings are considerable. There’s also a new generation of automated portfolio managers, or robo-advisers, that provide low-cost allocation using index funds.

As the number of indexes continues to pile up, however, asset allocation will become ever more complicated. How much investors should pay allocators is a discussion for another day. But whatever the price, I suspect it will be higher than the fees they save on index funds.   

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

To contact the author of this story: Nir Kaissar in New York at [email protected] To contact the editor responsible for this story: Daniel Niemi at [email protected]

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