Read This Before Buying Fidelity's Zero-Fee Funds

Video how to invest in fnilx

There are a few things in life you can expect to get for free: T-shirts, pens, and maybe the occasional koozie. But rarely do financial firms offer to manage your money at no cost at all. That’s exactly what Fidelity is doing with its line of zero-fee funds, four index funds that look a lot like some of the most popular funds on the market, with the exception that they cost nothing at all.

It’s a loss leader for Fidelity, but it could be a boon for some penny-pinching investors. Here’s what you need to know about the four no-minimum, no-fee funds Fidelity will let you buy and hold without paying a dime in expenses.

A fund for (almost) every U.S. stock

Nothing says “index fund” quite like a total market index fund. The Fidelity ZERO Total Market Index Fund (FZROX -1.44%), and funds like it, essentially invest in every single company listed on U.S. markets with only a few exceptions.

In this case, the fund excludes companies that have a market cap of less than $75 million and six-month trading volume of less than $25 million. Buying shares of smaller companies is hard to do without moving the market, so index funds generally avoid the smallest of public companies. Index funds and “nanocap” companies are like oil and water – they don’t mix very well.

Even so, this fund is as diverse as it gets, given it has about 2,500 holdings. Because it invests more money in the most valuable companies on the market, large-cap stocks make up the majority of its portfolio (the 10 largest stocks make up 18% of the portfolio).

This fund is just like any other fund that bears the “total stock market” or “total market index” name, making it most comparable to a Russell 3000 index fund. When you buy this fund, you own virtually every single U.S.-listed stock in proportion to its worth as a percentage of all U.S.-listed stocks out there. That’s why funds like these are the closest thing to truly passive stock investing.

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A copycat of the biggest and most popular index funds

It doesn’t take much investigative work to figure out that the Fidelity ZERO Large Cap Index Fund (FNILX -1.35%) is designed to replicate the most popular stock index funds on the market – S&P 500 index funds. Of course, Fidelity will never advertise it as such, because doing so would require that Fidelity pay a hefty licensing fee to borrow the S&P 500 brand name. (Technically, this fund tracks the nondescript Fidelity U.S. Large Cap Index.)

The case for investing in the S&P 500 is simple: The roughly 500 monstrous companies that make up the index together comprise a little more than 80% of the U.S. stock market’s value.

Fidelity’s copycat has only a short operating history, but it’s managed to perform roughly in line with the S&P 500 over the three-month period since its launch, lagging by about 0.08%. I suspect that the fund’s ability to match the returns of the S&P 500 will improve as it grows. At $227 million in assets, it simply doesn’t have the scale (yet!) to match the index as well as larger, true S&P 500 funds.

Top off your portfolio with some smaller stocks

An extended-market index fund is typically a complement for another fund. In this case, the Fidelity ZERO Extended Market Index Fund (FZIPX -2.29%) is meant to be paired with the Fidelity ZERO Large Cap Index Fund because it holds stocks that are too small to get included in the large-cap party.

Whereas the Fidelity ZERO Large Cap Index Fund invests in roughly 500 of the very largest companies on U.S. exchanges, this fund invests in the 2,000 stocks that didn’t make it in because of their size. To put it simply, if you add the stocks in this fund to the stocks in the Fidelity ZERO Large Cap Index Fund, you’ll have all the holdings in the Fidelity ZERO Total Market Index Fund.

This fund is yet another knockoff. It’s basically designed to be an alternative to funds that are based on the S&P Completion Index, which includes roughly 3,000 stocks that aren’t in the S&P 500. It holds roughly 500 fewer stocks than the S&P Completion Index, but arguably those smaller companies are a rounding error, given the market cap weighting (more money is invested in larger companies).

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Invest abroad…for free

It’s a simple fact of life that international stock funds typically carry higher fees, but Fidelity ZERO International Index Fund (FZILX -1.45%) is completely free. The fund is designed to invest in the vast majority of the most valuable companies listed on international exchanges. If you combine this fund with the Fidelity ZERO Total Market Index Fund, you’ll own a piece of just about every investable stock in the U.S. and abroad.

This fund is another knockoff that, for practical purposes, is designed to produce returns similar to those of funds that track the MSCI ACWI Ex USA Index, including the Fidelity Total International Index (FTIHX -1.47%). The difference between Fidelity’s free ZERO fund and almost-free Total fund (it carries an expense ratio of 0.06% per year) is that the free alternative holds substantially fewer stocks. The ZERO fund has over 2,300 holdings versus nearly 4,700 holdings in Fidelity Total International Index.

When it comes to performance, though, these funds differ very little – at least so far. In the fourth quarter of 2018, the only full quarter in which both funds were in operation, the ZERO fund modestly outperformed its comparable non-free Fidelity fund. Whether one outperforms the other will largely come down to international small caps, which are included in the Total fund but generally excluded from the ZERO fund.

Should you use Fidelity’s free funds?

Free is good, but it’s not always great.

It’s important to remember that Fidelity’s ZERO funds compete with funds that are already among the least expensive on the market. Plain-vanilla index funds can be found with expense ratios of 0.10% or less, which means you’d pay all of $0.10 per $100 invested to invest in those “name-brand” funds with long operating histories to analyze.

For investors who are just getting started, the benefits of a $0 minimum investment and no expenses is tough to beat. The only cost associated with investing in Fidelity’s free funds is using a Fidelity brokerage account. If you’re a new investor who just wants an inexpensive way to start investing small amounts of money, Fidelity’s free funds are incredibly compelling.

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Investors who have larger sums to invest, as well as those who invest in taxable accounts, may want to stick with the tried and true for now. Fidelity’s free funds are still minnows compared to the established, low-cost index funds against which they compete. Until we have more history, it’s smart to assume Fidelity’s ZERO funds will likely generate returns that deviate from the indexes they “track.”

In any given year, the Fidelity ZERO Large Cap Index Fund could easily post returns that are 0.2 percentage points higher or lower than the S&P 500, for example, which may negate the cost savings of a nonexistent expense ratio. (To be clear, that fund doesn’t claim to track the S&P 500, though it is as close as it gets to being an S&P 500 index fund without actually being one. Wink, wink.) If you have $1 million in the market, a hypothetical 0.2-percentage-point divergence from the index is material ($2,000) and the differences only compound over time.

For investors who use taxable accounts, mutual funds of any kind – even free ones – are an easy “pass.” For reasons that go far beyond the scope of this article, if you have the choice between an ETF or a mutual fund, and both track the same or very similar index, you’re almost always better off with the ETF. The reason is that ETFs are often far more tax efficient than mutual funds, meaning ETFs generate fewer taxable capital gains than comparable mutual funds. According to one study, investors who held the 25 largest ETFs in 2015 effectively dodged taxes on nearly $60 billion of gains.

To boil it all down: Fidelity’s free funds may not be perfect – no funds are – but their value proposition is most clear for beginning investors who plan to invest in a tax-advantaged retirement account.

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