Fidelity offers new zero-cost mutual funds – should you switch?

In the investing world, there's no such thing as a free lunch. But that all changed last week, when Fidelity Investments, the mutual fund and brokerage giant, launched two stock index funds with zero expenses.

To be clear, this is a unique thing in the financial industry. It costs a firm money to operate a fund, which includes costs for things like office space, employee salaries, trading, regulatory filings and legal expenses. Fidelity is the first major fund manager willing to absorb these costs for two of its index funds. The new zero-cost funds mean that investors in these funds will experience the same returns as provided by the broad range of stocks that make up the index, without any loss of returns because of fees.  

The two new funds are the Fidelity Zero Total Market Index Fund (FZROX) and the Fidelity Zero Internal Index Fund (FZILX.) The total market index fund seeks to provide the investment returns of the broad market of U.S. stocks. The International index fund seeks to provide the returns of stocks in both foreign developed markets and emerging markets. In addition to being zero cost, both funds are offered with no minimum to invest.

If you're looking to invest money in an index fund, it's hard to find a reason not to use Fidelity's new zero-cost index funds as part of your portfolio. But if you already own a total market index fund at Fidelity or at another firm, should you sell it and invest the proceeds into Fidelity's zero-cost index fund offering?

Investors in taxable accounts looking to switch to Fidelity's new zero-cost index funds need to consider both the cost savings and the taxes on any realized gains before making this change. 

As for cost savings, the typical expenses on an index fund such as those offered by Vanguard or Fidelity are in the 0.04 percent range, which is four hundredths of one percent. This comes out to an annual cost of approximately $40 per year for each $100,000 invested.

As for the tax costs of the switch, let's say your original investment was in 2010 for $50,000. If your fund is now worth $100,000, your gain is approximately $50,000. If you sold the fund to buy the new zero-cost fund, you'll owe capital gains tax of approximately $10,000, when considering a federal rate of 20 percent on the realized long-term capital gain. This tax cost could be higher because many states also impose their tax on capital gains. When considering the savings of $40 per year, it would take 250 years to recover the tax bill of $10,000. The time could be even longer because this does not take into consideration the future investment gains on the money used to pay tax now as opposed to paying the tax in the future. In this example, it doesn't make sense to switch. Also consider that Fidelity's race to zero on its index funds will put pressure on other funds to lower expenses on their funds soon, so sitting tight is the better move on a taxable account. 

(Investors in pre-tax retirement plans like a 401(k), or an after-tax Roth IRA whose gains grow tax free, need not be concerned with the potential costs of capital gains taxes and can focus solely on judging the potential cost savings from switching.)

Fidelity, with $2.5 trillion in assets in its mutual funds and exchange traded funds, has built a reputation on its actively managed funds, such as the Fidelity Contrafund, managed by superstar manager Will Danoff. But over the past 10 years, investors have moved significant assets into passively managed index funds which give broad exposure to the stock markets.

That's because actively managed funds suffered heavy losses in the aftermath of the financial crisis -- sometimes bigger losses than what even index funds suffered. Investors took note and decided that active managers who often performed worse than low-cost index funds -- and typically charge fees of one percent or more -- weren't worth the cost. Investors decided that if an actively managed fund wasn't going to protect them during a down market, then they may as well shift assets to the lower-fee index funds.

Ten years ago, Fidelity and Vanguard ran neck and neck in terms of assets under management. Now Vanguard -- the largest provider of index funds -- manages more than twice the assets as Fidelity does. With the new zero-cost index funds added to its offerings, it looks like Fidelity aims to change that.