One of the most significant investment trends over the past decade has been the shift from active investing to passive investing. A recent Charles Schwab article predicts that within the next 3-6 years U.S. investors will have more than half of their investable assets in some type of index-based product. This is an increase of more than 35 percentage points since 2006, validating the significance of this trend. In response to the strong demand for passive investments, some of the largest asset managers have slashed fees in hopes of luring new investors away for their competitors.
On August 1st, Fidelity was the latest asset manager to make a move to undercut its competitors. The company decided to consolidate their current four share class system into a single lowest cost share class product, eliminating all minimums at the same time. Fee reductions varied in magnitude depending on the index fund, and in some cases were substantial on a percentage basis. However, the market has seen other price reductions in the past. In March 2017, Schwab lowered the fees on all their index products to match the fees of their ETF offerings. They also consolidated their offerings into a single share class. In June of 2016, Fidelity reduced the fees on their index products to be more competitive with index behemoth Vanguard. This fee reduction trend is expected to continue as index providers increase their efforts to gain market share.
Although lower fees always benefit participants, there are additional factors plan sponsors should consider before deciding to switch index providers. One factor that needs to be considered is the benchmark the index is attempting to replicate. Participants invest in index funds with the expectation of replicating the returns of a specific index. However, not all benchmarks are the same. Some have differentiating features, such as market cap and number of constituents, affecting both the potential risk and return. Plan sponsors need to consider the tracking error of an index product offered within the plan. The tracking error measures the historical deviation in returns of the fund and the index. A fund with a lower tracking error better replicates the index. Another factor that plan sponsors need to consider is securities lending. This is the practice of lending out shares of a security owned by the fund in return for a fee and collateral with the hopes of adding a few extra basis points of return. With any type of lending practice there is the inherent risk of default of the borrower, which places a large amount of emphasis on the collateral the fund requires. Each manager’s approach is different. Some managers have a more conservative practice in that they only accept cash as collateral, while others may have a more lenient practice, as they may accept multiple forms of short duration fixed income securities. Finally, just like with actively managed funds, plan sponsors should be aware of the organization’s culture and the experience the index manager has within the industry. The overall expectation is that as assets grow, the manager should be able to create more efficient processes and in the long run have the ability reduce costs for participants.
With firms constantly trying to make their index products more attractive from a fee perspective, plan sponsors need to make a holistic decision—not simply reacting to fee reductions, but also considering all the factors that will provide a complete picture of the value of a specific index fund.
 “Eyes on the Horizon: What Could Cause the Next Crisis?”, Charles Schwab, August 2018.