Looking for the cheapest index funds? Try Fidelity

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Here's a distinction Fidelity Investments never really wanted: selling the cheapest index funds on the market.

Earlier this summer, the Boston-based firm cut fees on 27 index funds and exchange-traded funds, making them less expensive than competing offerings from Vanguard Group, its larger rival.

"They are now officially the cheapest across the board" in terms of indexes, said Katie Reichart, associate director of equity fund analysis at Morningstar Inc.

It's a scenario that was once unthinkable for a company that rose to the top of the industry on the exploits of star managers like Peter Lynch and Jeff Vinik, who were paid handsomely to select stocks and who routinely outran market averages by wide margins. Fidelity, which invests $2.1 trillion for clients, nurtured stock pickers and for the most part left index funds, designed not to beat the market but to match benchmarks such as the Standard & Poor's 500, to Vanguard and others.

But the world changed. After the financial crisis of 2007-2008, investors began moving out of actively managed funds and into index funds and ETFs, and recently the trend has been accelerating, according to Morningstar, a Chicago-based fund tracking firm. While investors directed $185 billion to active funds in 2012, all that and more flowed out in 2015 — $223 billion. This year’s drop is on track to be steeper still.

Largest Fidelity funds compared
Fund Active/passive Expense ratio Estimated 3-year flow 3-year return
Fidelity Contrafund Active 0.70 -$22.9 billion 11.97%
Fidelity Low-Priced Stock Active 0.79 -$12.1 billion 7.94%
Fidelity Growth Company Active 0.87 -$21.5 billion 13.12%
Fidelity 500 Index Investor Passive 0.10 $14.8 billion 12.24%
Fidelity Total Market Index Investor Passive 0.10 $8.0 billion 11.56%
Fidelity US Bond Index Investor Passive 0.22 $6.4 billion 4.27%
SOURCE: Morningstar, results through Aug. 29, other data through July 31, 2016

In years when the market has fallen, investors took refuge in passive funds run by computers, after active funds did no better than a comparable index — and often fared worse. In addition, employers that offer workplace retirement plans are under pressure to provide the lowest possible fees and best performance to workers.


Now, index funds pull in more money even when stocks are rising.

"Why are you going to overpay for the hope and a prayer?" asked Randolph Cohen, a senior lecturer in finance at Harvard Business School. "The competition is just so much tougher."

With its latest push in passive funds, Fidelity is playing an aggressive game of catch-up. But it also remains a stock-picking firm at heart.

The current environment "is very much a cyclical phenomenon," said Brian Hogan, the company's head of stock funds, who keeps a dense chart lined with names and numbers, tracking every Fidelity manager who is beating the market, by even 1 percentage point — and those who are not.


"There are times when active managers do better than passive, and times when passive managers do better than active,'' Hogan said. He blames low interest rates being maintained by central banks around the world for propping up some securities artificially.

If rates eventually rise, he predicted, "that would be an incredibly rewarding environment for Fidelity" and other active firms. "A scenario where we stay in a very low-inflation, very low absolute level of interest rate environment, where interest rates continue to fall, that might be a tougher environment."

Meanwhile, the pain continues for Fidelity and other active fund managers. Over three years through July, investors withdrew $73 billion from Fidelity's active funds, according to Morningstar. And customers moved $55 billion into the firm's passive index funds.

That mirrored the industrywide trend. Over the same period, US investors across all firms pulled $311 billion out of actively managed mutual funds, while plowing $1.2 trillion into passive funds and ETFs, Morningstar data show.

Fewer than half of all mutual funds have beaten the market over the past three years. Fidelity says two-thirds of its retail stock funds managed by the same portfolio manager for at least five years are beating their benchmarks over the manager's tenure.

Relying more on index funds is hard on Fidelity's profits. It takes a lot of assets in index funds to make up for lost fees on active funds.


While the average cost for Fidelity's index funds is now 0.102 percent, the average expense ratio for the firm's active equity and bond funds in 401(k) retirement plans is 0.75 percent, according to the company.

In the last three years, Vanguard, based in Valley Forge, Pa., has overtaken Fidelity as the largest 401(k) provider and has brought in more than 10 times as much passive money, or $612 billion, according to Morningstar. It also attracted $42 billion into active funds, a large slice of that run by Boston's Wellington Management Co.

"You can fight 'em or you can join 'em," said John Osbon, founder and managing partner of Osbon Capital Management in Boston, which manages $100 million in assets using passive strategies. "Active is very 20th century. Passive is very 21st century."

His son Max, also a partner at the firm, said the problem is performance even more than expenses, which get much of the air time from critics.

"There are a lot of mediocre active investments out there that popped up as the active world was expanding,'' Max Osbon said. "The really good ones, they'll stay around. It's the mediocre investments — those mediocre investments will go."

For some investors, especially in workplace 401(k) or 403(b) retirement plans, sorting out the good from the mediocre can be overwhelming. If your chances of beating the market are poor, why pay more for the gamble?

Fidelity's Hogan argues the opposite, that if investors can do better than the indexes over time, it's worth it. Earning just 0.25 percent more annually over 40 years of saving, he said, could provide an additional six years of income in retirement.


According to Hogan's "getting it done" chart, 67 percent of Fidelity's active equity and high-yield bond fund managers who've been on the same fund for at least three years are beating their benchmarks by at least 1 percent over their tenure, after fees.

For instance, over the 26 years that Will Danoff has managed Fidelity Contrafund, he has outperformed the S&P 500 index by an average of 2.84 percentage points annually. That means $10,000 invested in his fund over that period would be worth $219,729, compared with $113,800 for the index, Fidelity said.

More recently, however, over one, three, and five years, Contrafund, with $109 billion in assets, has not outperformed Fidelity's 500 Index Investor fund, according to Morningstar.

Raj Sharma, managing director for Merrill Lynch Private Banking and Investment Group in Boston, said he uses index funds for about 30 percent of a typical client portfolio. But he and others say the massive flows into passive funds could one day again open opportunities for active managers.

"By buying an index fund, people are sort of piling on to these big winners, and that creates problems,'' Sharma said, as it did during the 1990s tech bubble. "I've seen this movie before."

Beth Healy can be reached at beth.healy@globe.com. Follow her on Twitter @HealyBeth.