Are no-fee ETFs really free?

By Bryan Borzykowski on September 4, 2018
Estimated reading time: 4 minutes

Horizons and Fidelity recently launched no-fee funds. Here's the catch.

The years long fight against high fund fees has finally reached its zenith: Last August, Horizons ETFs and Fidelity Investments launched no-fee ETFs—funds that charge no management fees. With several ETF companies dramatically reducing their investor costs over the last couple of years, it was only a matter of time until someone started offering fee-less funds.

However, we were all taught at a young age that nothing in life is free, or that if it’s too good to be true then it probably is. So, do no-fee funds really cost nothing? Not exactly.

The cost of underlying funds

Let’s start with Horizon’s two no-fee funds, which, unlike Fidelity’s offering, is available to Canadian investors. The company is advertising its funds—the Horizons Conservative TRI ETF Portfolio (HCON) and the Horizons Balanced TRI ETF Portfolio (HBAL—as the first ETFs with “0% direct management fees.” While it’s true that these funds come with no management fees, investors will still have to pay something to own them.

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These products are fund-of-funds, meaning they hold a basket of Horizons ETFs, like the Horizons S&P 500 Index ETF in HBAL and the Horizons Canadian Select Universe in HCON. While the company is correct in saying that it’s managing these funds for nothing, investors must still pay the expense ratios on the underlying ETFs, which, Horizons says, won’t exceed 0.18%.

As well, the Horizons ETFs in these funds use a total return swap to mirror the return of an index—they don’t own any securities directly—and that process costs money, which is charged back to the investors. The “trading expense ratio” will cost investors no more than 0.2%, says Horizons, making the total cost of these funds, at the most, 0.38%.

Horizons president and CEO Steve Hawkins says investors are still saving money because the company isn’t charging any costs to operate the fund. While they “earn their fees indirectly through the direct management of the underlying ETFs, we are charging you nothing for this product,” he says.

Dan Hallett, vice-president of HighView Financial Group, thinks the no-fee claim is more marketing speak than anything else, adding that if this were a mutual fund, it would not be allowed to make the no-fee claim. Mutual fund of funds can’t charge people for the underlying securities—all fees must be wrapped up into one overall MER.

The real selling point, he says, is not that it’s no-fee, but that it’s that these are the first Canadian ETFs to hold a basket of tax-efficient total return swap funds. Since the underlying funds don’t hold actual securities, they don’t pay out taxable dividends or interest. The gains are considered capital gains, which only get taxed, at the capital gains tax rate, when investors sell the funds.

The fight for more market share

As for Fidelity’s no-fee ETFs, the Fidelity Zero Total Market Index Fund and the Fidelity Zero International Index Fund, these funds are truly free. But there’s still a catch: Only people who use their brokerage firm can buy them (which is why they’re not available to Canadians) and, to save money on index-licensing fees, these funds are based on new propriety indexes, which have no track record.

Fidelity is fine with taking a loss on these funds to get more people to use their brokerage firm, where they’ll likely end up buying other funds or products that do have fees, says Hallett. However, he says that since financial institutions don’t typically like to lose money, if people aren’t enticed by the company’s no-fee options, then they could start charging a MER or roll them up into similar products that do have fees.

There are other ways Fidelity, and other companies that eventually issue no-fee ETFs, can make money off their products, including by lending some of the securities in a fund to another firm —often a short seller—in exchange for a fee. Firms can make a lot of money through lending, often enough to cover any fee-related shortfall.

Securities lending isn’t necessarily bad for investors, says Hallett, but it poses some risks. One main one is that the borrower may default, forcing the fund firm to buy back the securities it lent out. The collateral the borrower put up may not be enough to fund the repurchase of those stocks. Fidelity says it’s not engaging in securities lending to cover the cost of running their no-fee funds, but it does engage in the practice.

The bottom line is to read the fine print, says Hallett. Fund companies, which are in the business of making money, are not slashing fees for altruistic reasons. While it may be possible for these companies to make more for themselves, while also saving people money, always remember that no-fee doesn’t mean free.

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