Fidelity Released Zero Fee Index Funds
The exploding popularity of low fee index index funds in recent years has been putting pressure on brokerages to push their index fund expense ratios even lower. About a year ago, Fidelity ramped up that battle when they released four 0% expense ratio index funds, including FZROX a zero fee Total Market Index Fund.
Expense Ratio War
Here’s a look at a US total market index fund from each of the three major discount brokerages:
|Brokerage||Ticker||# Stocks||Net Assets||Expense Ratio|
The Dirty Little Secret
On the surface, the new FZROX looks like it just won the war on expense ratios. But hidden inside these new index funds is a dirty little secret. Take a look at their dividend distribution schedule.
|Vanguard||VTSAX||Quarterly (March, June, September, December)|
|Fidelity||FSKAX||Semi-Annually (April, December)|
VTSAX Pays Quarterly
Vanguard’s VTSAX stands alone as the only one of the bunch to distribute dividends quarterly. That means FZROX (and SWTSX) are sitting on dividends for up to a year before releasing that cash to the investor. Dividends make up an important part of the growth of a fund when reinvested. The opportunity cost of reinvesting those dividends annually instead of quarterly turns out to be (relatively) expensive.
An Analysis of The Annual Dividend Effect
This spreadsheet shows a hypothetical recreation of both FZROX and VTSAX over the past 40 years if they were tracking the S&P 500 index. It takes into account the expense ratio of each fund as well as the respective dividend reinvestment schedules. When you look at the net effect over 40 years, the cost of waiting to reinvest those dividends until the end of each year ends up costing FZROX more than the 0.04% expense ratio of VTSAX. An initial $10,000 investment turns into $714,671 for FZROX and $725,999 for $733,569, a difference of $18,898 or about 2.6%.
FZROX Costs About 0.15% Per Year
For those hyper sensitive to expense ratios, this cost has the net effect of a 0.15% inefficiency to the market. Despite VTSAX’s 0.04% expense ratio, VTSAX only trails the market by 0.07%, less than half that of FZROX. As long as there’s positive growth, annual dividend reinvestment will always incur a cost to the growth over quarterly. The bigger the increase in share price and the bigger the dividends, the larger that effective cost becomes.
VTSAX Still King
So with the largest net assets, the most stocks in the portfolio and the only fund to pay dividends quarterly, VTSAX is still king of the total US market index fund game.
Don’t Chase Tiny Differences in Expense Ratios
That said, the real lesson here ISN’T to dump your current index fund in search of an ever so slightly more efficient one. Even FORTY YEARS down the road, the difference was only about 2%, or a single good or bad day in the market. Instead, focus your energy on investing early and often and staying the course. One panic during a market downturn will more than wipe out any benefit a tiny decrease in expense ratio provided.
Fidelity’s new zero fee index funds only pay out dividends once per year. The opportunity cost of not reinvesting those dividends sooner is about 0.15% per year.
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In regards to the top level comment about sitting on the dividends. I didn’t mean to imply the brokerages actually hoard cash scrooge mcduck style for a year. I’m sure they’re using that money, reinvesting, etc. But if that doesn’t translate to an actual increase in share price, then there’s still an opportunity cost to the investor.
TO TEST THIS: I went back to the 14 months of data we actually have available since FZROX was introduced and tracked the exact share price and exact dividend dates and dividend reinvestment dates. You can see that work on the second page of this spreadsheet. The FZROX share price HAS actually outpaced VTSAX’s share price. But when you add in the dividends, VTSAX actually makes up for that and then some in the actual growth of the investment, outpacing FZROX by 0.008%. My hypothetical recreation of the last 40 years above had VTSAX outpacing FZROX by 0.08%. So, maybe FZROX is internally reinvesting in a way that impacts share price? But not enough to stay ahead of VTSAX’s efficiency with the index and quarterly reinvestments? Also, this “opportunity cost of slower dividends” ONLY takes effect when the market is UP. If the market is DOWN, getting your cash later (and buying at a lower price) actually benefits the investor. And the market has been pretty volatile/flat for the last year which backs up my original hypothesis.
Disclaimer: This content does not necessarily represent the views of IWB.