Who's Winning the Index Fund Price War?

Last Updated Oct 8, 2010 2:47 PM EDT

Vanguard brought a smile to the faces of their index fund investors this week with their announcement that they were lowering the threshold for entry into their Admiral class shares. The share class, which carries expense ratios as low as 0.07 percent, was previously available to investors with a minimum fund balance of $100,000. For their index funds, that threshold has been slashed to $10,000.

Vanguard's announcement is merely the latest shot in what has become a years-long price competition among the three largest providers of indexed mutual funds. But now that we're more than six years into this price battle, it's worth taking a look at who's winning.

Fidelity began the offensive in 2004, when they slashed the expense ratios on five of their Spartan index funds to 0.10 percent, and, a year later, to 0.07 percent. Both rates were markedly lower than the expense ratios charged for comparable funds by the previous low-cost leader Vanguard.

The move generated a great deal of attention from the press, but remarkably little in actual investor dollars. In 2004, for instance, Fidelity received 10 percent of all net new cash flowing into equity index funds (excluding exchange-traded funds). That share increased by 75 percent to 17.5 percent in 2006, but the deluge quickly dried up. By 2009, their share was down to 3.5 percent, and it's actually negative year-to-date.

In 2009 Schwab entered the fray, slashing the expense ratios of their broad market index funds to as low as 0.09 percent. And unlike their two competitors, Schwab's low-cost funds were available with a minimum investment of just $100.

Schwab got even less bang for their buck than Fidelity did. Their share of index fund cash flow went from negative in 2008 to 1.3 percent in 2009, but has fallen to 0.3 percent in 2010.

The rationale for the Fidelity and Schwab expense reductions was that they would enable the firms to beat Vanguard at its low-cost game, as the fund managers siphoned off a portion of Vanguard's cost-sensitive index fund investors. Even better, so the logic went, once in-house, those investors might decide to shop around, and sample some of the firms' pricier actively managed funds.

But that's not how it has played out. At the end of 2004, Vanguard (68 percent), Fidelity (9 percent) and Schwab (5 percent) ranked first, second, and third in market share of equity index fund assets. Today, their ranks remain unchanged, but Vanguard has actually increased their market share to 72 percent. Fidelity's has risen slightly to 10 percent, which Schwab's has fallen to 3 percent.

So why have Fidelity and Schwab received so little attention from index fund investors? It's impossible to say for sure, but perhaps one reason is that while index investors as a group recognize the enormous benefits they'll accrue by slashing their expenses from 1.5 percent in actively managed funds to 0.18 percent or so in an index fund, they also realize that the benefits of going from 0.18 percent to 0.10 percent are much more modest, and perhaps not worth the hassle (and tax consequences) of switching from one index fund provider to another in mid-stream. Further, the idea that Fidelity and Schwab would be able to recoup some of the fees they lost on their index funds by selling their new investors a handful of actively managed funds always seemed a bit of a reach. Almost by definition, any investors they lured would be among the industry's most cost-conscious, dyed-in-the-wool index believers. The notion that a majority of those investors would be tempted to invest in one of the firms' actively managed funds simply because it was a bit easier to do so seemed to be a hope too far.

So now, with Vanguard's recent announcement, Fidelity and Schwab seem to find themselves in a situation in which they're subsidizing a losing strategy. Because their expense reductions are simply fee waivers, Schwab can take the easy way out and decide to cut their losses. Fidelity, on the other hand, made their cuts permanent, and can only increase their index funds' expense ratios via a shareholder vote. By my calculations, Fidelity's fee reductions on their four equity index funds will cost them in the neighborhood of $60 million this year alone. Granted, that's a mere drop in the bucket for a firm with a reported operating income of $2.5 billion in 2009. But it's not chicken feed, either. While Fidelity's and Schwab's index fund investors reap the benefits of the firms' lower-cost index funds, I wonder if at some point the managers might decide that their index fund battle is not worth the costs they're incurring.

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  • Nathan Hale

    View all articles by Nathan Hale on CBS MoneyWatch »
    Nathan Hale has spent decades working in the financial services industry, during which he has researched and written extensively about personal investing, the mutual fund industry, and financial services. In this role, he uses a nom de plume because many of his opinions about the mutual fund industry and its practices would not endear him to its participants.