When it comes to investing, fees are crucial. The lower the fees, the more money you keep in your pocket. That's why so many investors are drawn to zero fee funds like Zero Total Market Index Fund, also known as FZROX. But is this too good to be true? Is there such a thing as a free lunch? In this post, we'll take a closer look at FZROX and what makes it unique. We'll also explore whether or not its low fees come at a cost.
01 - FZROX General Overview
Fidelity launched its ZERO index funds in 2018 garnering a lot of attention. And well deserved attention at that given for the first time in the index fund industry, Fidelity was introducing funds with no expense ratios. That is right, you get to invest with Fidelity for free. There are four specific funds that were introduced:
On the surface, the Fidelity ZERO Total Market Index is a simple total US Stock Market Index Fund. Very similar to the original Fidelity total US stock market index fund, the Fidelity Total Market Index Fund, FSKAX. It aims to invest in pretty much all publicly listed companies in the US stock market. Pretty straightforward right?
And another nice fact about investing with Fidelity is that there is no minimum investment requirement. Yes, that is right, not only does it charge nothing to invest with, you don’t have to bring a minimum investment to play.
Vanguard, as many of you know as my personal favorite investment firm, often has a $3,000 minimum in order to invest with many of its index funds. Well with Fidelity, no need to save up $3,000. You can start investing right away with anything you got. Maybe there is such a thing as free lunch?
02 - FZROX ‘Loss Leader’ Strategy
Well before we think Fidelity and FZROX is the greatest thing since sliced bread, let’s cover some other not so well known facts. A lingering question that many of us, including myself, have asked when we first hear about FZROX is this. How can Fidelity not charge a fee with FZROX and its other zero index funds? Are they just being generous? Is this part of their give back to society program?
Well no. Far from it. Fidelity is not a charity and they aren’t looking to lose money. They are a private firm and bring in billions of dollars in revenue every year. Therefore, though Fidelity doesn’t specifically make money from FZROX, they are deploying it as a means to make more money down the line. How? Through a strategy called ‘loss leader.’ It's designed to get investors in the door so Fidelity can cross-sell the customer into different funds, financial advisor relationships, brokerage accounts and other products.
It's similar to Costco’s $1.50 Hot Dogs. For decades Costs has been selling this signature food court item, a footlong hotdog and a soda for $1.50. It’s how I fed my kids since they were toddlers. Costco’s strategy isn’t to make money from their $1.50 hotdogs. It is to get people to come to Costco. Unsuspecting naive customers like myself.
I would initially go to Costco for some hotdogs but before you know it I find myself in one of their aisles buying toothpaste, blankets, liquid soap, and anything else you can think of. In the same way Fidelity’s strategy is to use FZROX and the other zero funds to lure in new customers to Fidelity. And from the looks of it, it looks like it has worked quite well so far. FZROX has attracted nearly $12 billion in assets in a period of just under 4 years. Competing directly with the index fund giant, Vanguard.
Now they haven’t disclosed how much they are making from all the cross selling to new customers, but I’m assuming with $12 billion in assets under management with this one fund alone, they are finding some level of success.
Alright, you might be thinking at this point. I get it. Fidelity isn’t a charity and I see their business strategy with FZROX. But that is cool with me. I don’t get easily swayed by fancy new products Fidelity is going to try to sell me, so I’m just going to have the cake and eat it too.
03 - FZROX Proprietary Index
However, before you jump to that conclusion let me share with you another interesting fact about FZROX. Fidelity ZERO Total Market Index Fund advertises itself as a fund representing the total US stock market, but how true is this statement?
One of the most comprehensive US stock market indexes is the CRSP US Total Market Index. An affiliate research institute of The University of Chicago Booth School of Business. Based on this index there are approximately 4,000 US companies total across mega, large, small and micro capitalizations.
However when we go to Fidelity's website, we see that FZROX represent slightly under 3,000 (2,911) companies as of Sept 2022. Why is that? Why the difference?
The reason is because FZROX does not track the CRSP US Total Market Index as its benchmark. Or the other more well known total market indexes like the Dow Jones U.S. Total Stock Market Index or the MSCI US Broad Market Index. It tracks a proprietary index Fidelity created in-house. The Fidelity U.S. Total Investable Market Index.
According to Fidelity, this index is designed to reflect the performance of stocks of large and mid capitalization US companies. It has certain criteria for excluding companies. For example, the index excludes companies with capitalizations under $75 million or with limited trading volume. And it also caps the index to 3,000 companies. Less if the final count does not survive the liquidity and investability screens.
Fidelity Total Market Index Fund, also known as FSKAX is Fidelity's original total market index with an expense ratio of 0.015% on the other hand represents close to 4,000 (3,977) US companies by tracking the Dow Jones US Total Stock Market Index.
I’m assuming Fidelity is able to save some money on FZROX by tracking its own proprietary index versus paying a licensing fee to use other benchmark indexes.
Now before you think FZROX is ripping you off we do need to understand the scale of this impact. A difference between 4,000 and 3,000 looks like a lot on the surface. However we need to remind ourselves that when a company is being represented in these funds, they are represented based on their market capitalization - their size. So a small company would not have the same level of representation as big boys like Apple or Google.
The percentage representation of the top 10 companies between FZROX and FSKAX, is barely noticeable.
FSKAX at 23.33%
FZROX at 23.41%
A difference of 0.08%. What this means is that companies that are excluded in FZROX from FSKAX are actually less than 1% of total market capitalization. So while FZROX does exclude close to thousand companies from its index, they are all very small companies and the impact is not as big as we might deem. And this is reflected in the returns as well.
When we compare the 3 year returns between the FZROX and FSKAX, there is a slight difference. FZROX had a slightly higher return at 7.68% versus FSKAX’s 7.51%. FZROX was created in 2018 so we can’t go back any further.
The difference is likely driven by the fact that the largest US companies in these cap-weighted funds had higher returns than small cap and micro cap funds excluded from FZROX. Of course only time will tell if this trend will continue.
My primary concern with the fact that FZROX follows a unique inhouse index is this: we don’t know how and when they can change it. Right now it looks like it doesn’t deviate too much from the other total market indexes in the market. However, only time will tell. Could Fidelity one day decide to exclude mid cap companies from this index? Other other high performing companies? Likely not but who knows right?
04 - FZROX Portability
And this leads to another interesting fact that should make us take a pause before we invest everything into FZROX. It’s portability. When you decide to invest with FZROX you have to consider it like a marriage. You are making some solid commitment. Until death do us part.
What do I mean by this? Most other funds in the market are pretty flexible when it comes to portability. You might start out with a fund like FSKAX, Fidelity Total Market Index Fund, but you might decide that you want to switch. Not a problem. These kinds of transfers are pretty common and called transfer “in kind.” You simply move your investments to the receiving investment firm "as is." There's no selling or buying involved and no tax consequences either.
However, not so with FZROX. With FZROX you cannot take your investments out of Fidelity without selling your holding. And doing that will mean you have to pay capital gains tax. Now a caveat, if you are on a tax-deferred IRA, you don’t have to do that.
If you are a lifelong Fidelity customer and have no desire to ever transfer your money out, this poses no problem. You are literally having your cake and eating it too. Bravo if you are in this situation.
However, many of us may not be so fixed. We might start out with Fidelity because they have an office near our work. Or we opened up an account with them when we were in college and just kept doing business since then. The bottom line is that FZROX doesn’t provide you a level of flexibility that other funds do.
Another quick major disadvantage is that FZROX and the other ZERO funds are available only through Fidelity. This could add another administrative layer to managing our money. If you have all your money with a different firm like Vanguard or Charles Schwab, it’s pretty inconvenient to open an additional account with Fidelity simply for the purpose of saving a couple of basis points on fees. A $10,000 investment in FZROX versus VTSAX saves someone a whopping $4 a year. Is the additional administrative work worth the cost?
05 - Tae’s Thought
Alright I shared with you a lot of things in this post so let me give you my personal take. Vanguard, as the pioneer of index funds used to offer the most cost effective index funds. Not anymore. Due to competition the cost of most index funds have fallen dramatically over the last few decades. A good news for average investors like you and I. Today we can easily invest in an index fund for less than 0.1% expense ratio. Most often even less than 0.05% expense ratio.
That said I feel like Fidelity ZERO Total Market Index Fund, the FZROX is more of a marketing strategy than a product that meets most investor needs. Yes, free beats even the cheapest cost. However the issue I have is that Fidelity achieves a 0% Expense Ratio by tracking its own proprietary indexes. And who knows where this index will go in the future? I’m not sure that risk is worth saving a few dollars each year. In addition when we add on the lack of portability, I just don’t feel comfortable with that level of commitment. I do like Fidelity, but are we talking about marriage already? With that said, I would still invest with FZROX if it was the best option available in my company sponsored 401k.
