Will Zero-Fee ETFs and Mutual Funds Destroy the Profitability of Investment Managers?

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When investors place money with mutual fund managers or invest in exchange traded funds and equities, they automatically assume that they will have to pay fees. These may be one-time fees, or they may be paid out each year. So what happens when investors hear that one of the nation’s top money managers is now willing to allow investors to buy two funds without any management fees at all?

The nation’s news flow has been rather distracting from some issues like this, but Fidelity Investments recently announced the launch of two indexed equity funds with no management fees — and there are no minimum investment requirements. Furthermore, Fidelity also said that it would have a 35% average fee reduction to its existing index funds.

Fitch Ratings has just issued a report showing that zero-fees will pose additional challenges for investment management firms. In a race to zero fees, some investors in these public asset managers and investment managers will have to wonder about the long-term profitability of an entire business segment within finance and banking. That’s what Fitch has brought up.

24/7 Wall St. decided to see how the recent Fidelity announcement has played out against the larger publicly traded investment management firms. By and large, shares did not perform badly despite investors hearing “no fees” and perhaps thinking that world of management fees and commissions would dwindle to zero over time. Here is how their shares have performed on a total return basis in the last week and so far in 2018:

Franklin Resources Inc. (NYSE: BEN), parent of Franklin and Templeton funds, shares are up 2.6% in the past week and up 14% so far in 2018. Franklin Resources has a market cap of $18 billion.

BlackRock Inc. (NYSE: BLK), which owns iShares and is the world’s top ETF manager, shares are up 1.6% over the past week but still down about 5% so far in 2018. BlackRock has $77 billion market cap and is the largest of this entire group.

E*Trade Financial Corp. (NASDAQ: ETFC), which manages assets and charges clients via the classic per-trade commission structure, was up about 1.8% in the past week, as well as up the most of the group (up by 23%) so far in 2018.

Charles Schwab Corp. (NYSE: SCHW), which manages assets and is the largest of the big-three discount brokerages, has seen its shares fall by less than 1% in the past week, and its shares are down almost 2% year to date. Schwab has a market cap of about $69 billion, and it is worth more than TD Ameritrade and E*Trade combined.

T. Rowe Price Group Inc. (NASDAQ: TROW), which manages mutual funds and manages assets globally under the same T. Rowe Price name, has seen its shares rise 2% in the past week and rise 14% year to date. Its market cap is about $29 billion.

According to the Fitch report, this new zero fee issue highlights the persistent industrywide revenue pressures that face traditional investment managers. If one firm is trying it out, other firms will follow. And if it applies to a handful of popular index funds, other index funds are likely to experience the same pressure. The Fitch report noted:

A broader roll out of zero-fee funds, or further reduction of current fee structures, would exacerbate the long-term earnings pressures facing traditional investment managers. This would be particularly challenging for less diversified firms lacking scale, and could spur additional mergers and acquisitions.

Fitch’s did not downgrade the investment management segment and it actually maintained a stable ratings outlook for it in its observations. Still, some investors would be smart to view this as a “long-term downgrade-lite” call. The report also noted:

However, should fee and flow pressure accelerate such that it results in EBITDA compression and consequent decline in profitability margins and/or an increase in cash flow leverage ratios, outlooks and/or individual issuer ratings. Although not viewed as an imminent threat, to the extent Fitch considers passive allocation sufficiently material and permanent, negative rating/Outlook changes could result in advance of the trend being manifested in financial metrics… Offering zero fee rates requires investment managers to have scale and/or more diversified business models with revenue streams other than base management fees such as securities lending or wealth management, which are only realistically achievable for a subset of larger, lower-cost players including Fidelity, Schwab, BlackRock and Vanguard.

Fidelity managed $2.62 trillion in assets as of the end of the second quarter. The company, just like Vanguard, is a privately held entity that does not have to issue earnings releases nor answers to thousands of shareholders who demand dividends and a consistent path to growing profits. Fitch also addressed this in the report:

The fact that Fidelity is privately held may also allow it to take a longer-term strategic view versus publicly traded managers that may face greater shareholder pressure for near-term results. Fitch does not rate Fidelity, and therefore does not have insight into the company’s strategic rationale beyond what can be inferred from information available in the public domain.

Before thinking that all publicly traded investment managers are doomed, note that Fitch did say:

Fitch believes that while passive fee reductions to zero from the typical three to five basis points may exacerbate active fund outflows, long-term investor appetite for actively managed funds will depend much more so on managers’ ability to outperform passive indices at various points in the cycle.