Investment fees have dropped so low that you may have assumed they have gone as far as they can, and the cost-cutting story is just about over.
Well, think again. Something mind-boggling is on its way.
Fees are on the verge of falling below zero. Major companies will soon be paying customers to invest with them. That, at least is the conclusion of the investment research firm Flowspring, which says the fund price wars are about to be fought in the previously unexplored territory of negative fees.
“Zero may seem to be the lower bound for fees, but it’s not,” Warren Miller, Flowspring’s chief executive, said in an interview. “As we’ve learned from interest rates, zero is a psychological barrier, not a real one. The fund industry is tottering on that barrier right now. Negative fees are coming.”
In a provocative essay, “The Game Theory of Fund Price Wars,” Mr. Miller writes that competitive fee-cutting has brought us to the edge of a new, negative-fee universe that is probably better for individual investors than it is for investment companies.
He compares the cost-cutting frenzy to a dollar-auction game, a behavioral finance staple in which participants bid for a dollar bill. Once the game starts, the “winner” of the dollar bill often ends up paying far more than $1. Playing the game is, in itself, a trap.
In the fund industry, Mr. Miller said, “This auction game has already started, even if people don’t all realize it.”
Consider that last month, a start-up, Salt Financial, filed a registration statement indicating its intention to market a negative-fee stock fund this spring. The fund’s expense ratio will be minus 0.5 percent. The Securities and Exchange Commission has not yet weighed in.
The Salt Financial filing says that the company’s founders plan to subsidize the fund until it attracts $100 million in investments. At that point, the subsidy, which amounts to no more than $50,000, would end. So would the fund’s negative fees, which would jump to 0.29 percent.
In short, this negative-fee fund is a first step: It is a promotional gambit, not a permanent strategy.
“It is difficult to break through in the current marketplace and reach investors,” Tony Barchetto, one of the fund’s founders, said in an interview. “We will be offering negative fees on a temporary basis, for our own strategic reasons,” he added.
The strategy has already gotten plenty of attention in the fund industry. “It’s the most creative and effective use of $50,000 in marketing money that I’ve heard of in a long time,” said Jon de St. Paer, the chief executive of Charles Schwab Investment Management.
I spoke with representatives of BlackRock, Fidelity, Schwab, State Street and Vanguard — large companies that offer index funds with fees of zero or close to it. None said they were planning to offer negative-fee funds right now, but none categorically ruled out doing so.
Yet if the Salt Financial venture is successful, other negative-fee funds will probably follow. For many companies, that would be a small step, Mr. Springer said.
Fidelity has already slashed fees to zero — yes, nothing at all — for four of its index funds. Other major companies are offering funds with costs so close to zero that the difference is scarcely measurable. And even if big companies aren’t advertising their offerings as negative-fee funds, some index funds are virtually there already.
Understanding this requires a quick descent into mutual fund plumbing. (Hold your breath. This won’t take long.) As a Morningstar report recently explained, most large mutual funds and exchange-traded funds, or E.T.F.s, are permitted to lend some of the securities they hold, often to short-sellers, who borrow the securities in the hope of selling them later at a cheaper price.
Vanguard, for example, says that for several of its low-cost index funds, the revenue that flows back into the funds from securities lending is so great that there is effectively no net cost to investors right now. In fact, the reverse is true: “You could say these funds are paying investors to hold them, but we’d never promote it as such,” John Woerth, a Vanguard spokesman, said in an email.
Vanguard Small-Cap E.T.F., which has a published expense ratio of 0.05 percent, is one such fund. Securities revenue, plus what Vanguard called “skillful portfolio management,” has enabled that index fund to beat the index it tracks over the past few years, said Rich Powers, who leads Vanguard’s exchange-traded fund operation.
Fidelity, which has been slashing costs and offers index funds that are cheaper than comparable Vanguard funds, also funnels securities-lending revenue back into its index funds. “We’re doing everything we can to keep costs low for our investors,” said Kathleen Murphy, president of Fidelity Investments’ $2.4 trillion personal investing business.
Last year, the Fidelity Small-Cap Index Fund, with an expense ratio of only 0.025 percent, generated more than 0.20 percent in securities-lending revenue, which it returned to the fund, Nicole Goodnow, a Fidelity spokeswoman, said.
In effect, Mr. Miller of Flowspring said, numbers like that make it possible for fund companies to make money even when they charge customers less than what he described as “a nominal fee of zero.” Furthermore, once they entice you into becoming an investor, most fund companies can extract revenue in many ways.
As always, buyer beware. Low cost isn’t everything: A bad investment or service is still bad, even if there is no fee attached.
For the most part, the cost-cutting revolution that Jack Bogle at Vanguard started decades ago has been a good thing. As I recently wrote, the low prices charged by investment managers have been dropping so much that they are dampening overall inflation to the point that the impact is showing up in government statistics. But as low costs spread, new problems may crop up.
Consider the pitfalls of business models that don’t require customers to pay direct fees. Facebook, Google, Twitter, Snapchat and others are examples. They mine their users’ personal data and generate immense revenue, although it is an understatement to say that not everyone is happy about this.
No-fee or negative-fee investment companies will have vast amounts of information about their clients. The successful ones will find ways of making money from customers who believe, initially at least, that they are getting a free lunch.
And if investment companies take greater risks with the assets entrusted to them to offset the fees they have given up, people of modest means will probably suffer. Greater scrutiny from regulators may be required to forestall far greater problems.
Nonetheless, cost counts for a lot. The downward fee spiral remains good news for millions of people, even if the fees drop below zero.