War! What’s it good for? How about reducing fees to nothing?

Yes, fund giant Fidelity is now offering North American investors a US total market equity index tracking fund and an international equity tracker fund with fees of 0%.

While many still complain the markets are rigged and that small investors get a rotten deal, Americans who do their research can now invest for free.

So is this it? Investing nirvana?

Not quite.

Firstly these funds are for US consumers – and British investors still seem to pay higher fund fees than US investors in general. That said, even we can get cheap index trackers costing 0.1% or less a year.

Cost-wise, going from there to zero isn’t as big a leap as ditching an expensive active fund charging 1% or more. The big wins have already been achieved.

More subtly, as my co-blogger The Accumulator likes to say even cheapskate passive investors know someone has to be paid somewhere. So what’s the catch?

I see two potential wrinkles.

Firstly, the new 0% funds track Fidelity’s own in-house indices, rather than indices from one of the benchmark behemoths. This will save them paying licensing fees to the likes of MSCI or FTSE, but many investors would prefer index homogeneity across the tracker fund universe.

Second, the 0% funds will probably lend shares to short-sellers for a fee, which Fidelity will pocket. Some feel this practice sees a fund’s investors taking the risk but the manager getting the reward.

Neither wrinkle would stop me investing.

All indices are constructs and I expect a company of Fidelity’s standing has put together something reasonable. (We’ll look into this in the future).

As for the stock lending, defaults on security loans in such circumstances are rare, and should be covered by collateral. The Accumulator has previously expressed concerns though, and it’s true stock lending does add counter-party and related collateral risk to what ‘should’ be a simple fund.

You’ll pay (or not!) your money and take your choice.

Heroes and zeros

One thing not to worry about is Fidelity’s bottom line. The firm achieves roughly $18bn in annual revenues. Most of that comes from managing retirement accounts, active funds, and share trading, not from trackers.

When we last did a roundup, the cheapest world equity index fund for UK retail investors was already from Fidelity, charging just 0.13%. But apparently they offer US investors an equivalent charging just a tenth of that!

Going from such low fees to zero won’t upset Fidelity’s business model anytime soon. Rather, the zero percent funds are a loss leader, like our free current bank accounts. The firm will aim to make the money up elsewhere.

It will also cause headaches for rivals such as Vanguard and Blackrock. These index fund giants are less able to go to zero without scything their revenues.

The future of active management

Eventually I think we’ll see an index fund that charges a negative fee.

That’s right – you’ll be paid to invest!

A fund would achieve this by passing on those stock lending fees to its investors. It’ll probably be a gimmick rather than mainstream, but what a powerful signal it would send.

Sometimes I have to pinch myself. I’m not that old, yet even I can remember when the standard way to invest was to pay an advisor a trail commission of say 0.5% a year forever for putting you into an active fund that charged 2% a year. As if that wasn’t enough, you also paid 3-5% as a one-off upfront fee for the privilege.

There are protection rackets with better terms than that.

No wonder we’ve seen a huge shift to passive investing. Active investing is a zero-sum game, so pound for pound, by charging higher fees the average active fund can only lose by comparison. Simple mathematics guarantees that while there may be a few market beaters, the majority will under-perform – just as the evidence confirms.

For the average edge-less investor (that is, nearly everyone) index funds offer the cheapest, simplest, and most likely path to investing wealth.

Of course, as more people understand this, the financial services industry tries to obfuscate the truth to protect its cash cows.

We’ve all read the articles that misunderstand how passive investing works and blame it on every market evil under the sun – from flash crashes to low returns to high volatility to job losses to, well, giving a toehold for Marxism on Wall Street.

More constructively, some have advanced theories as to how active funds can turn back the indexing hoards.

But these generally fail a quick inspection:

• Some say active funds must work harder to earn their higher fees. But active investing is a zero sum game. Tens of thousands of smart people are already busting their guts. Everyone works harder, pays more, and on a market wide level the under-performance will persist.

• Active investing should be the preserve of specialist hedge funds, say others. They overlook the fact that hedge funds as a group have delivered worse returns than a cheap 60/40 passive portfolio for more than a decade. And with over $3 trillion under management they’re no longer niche.

• Just wait for a crash! Then active funds will prove themselves over dumb index funds that will follow the market down! This overlooks the fact that active funds are the market. (Did someone say zero sum game?) Falling markets are caused by active funds selling shares, or at least being prepared to pay less for them. Where active funds do better in falling markets it’s typically because they always hold a wodge of cash ready for client withdrawals, not because of skill. Cash keeps its value. You can mimic this brilliant strategy by keeping some money in a High Street savings account, and save on the fund fees.

• A few optimistic people say the industry as a whole should pay for the price discovery service that active managers perform, which index trackers exploit for free. As long as active managers are the ones driving around in sports cars there’s zero chance of that happening.

• Some say active investing needs to be reinvented through simple Factor Investing / Smart Beta / Return Premium funds. These enable investors to buy into something supposedly more concrete than ‘magical’ manager skill. A retort is that factors may not persist – our own contributor Lars Kroijer is one skeptic.

That last is already happening, anyway, through the proliferation of factor-based ETFs. Their undeniable advantage versus traditional active funds (though not the cheapest market-weighted trackers) is they’re less expensive to run.

Computers don’t demand sports cars!

Active funds must cut costs to compete with zero

I believe that cost cutting is the only way that active funds can compete long-term.

The reason active funds do so poorly as a category is that in a zero-sum game, their high fees gnaw away at their returns.

Before costs are taken into account, there is a share of money in active funds that does beat the market – which is balanced by an equal weight that loses.

The net result is the market return (which is captured most cheaply and consistently by passive funds).

If active fund managers leveraged technology to cut costs across their businesses, they might be able to reduce their total expense ratios to best-in-breed pricing of say 0.3% or less.

That would still be two to three times as expensive as a decent equivalent index fund (let alone a free one) but at least it’d be competitive.

Many people seem to believe they deserve to beat the market. And they like humans managing their money more than machines. Passive investing feels wrong. That’s why the active industry persists.

If active funds were much cheaper, these notions wouldn’t be so consequential, and the case for choosing a tracker over a ‘fun’ flutter on a flavour-of-the-month manager would be weakened.

I don’t say that it would be logical for the average investor to then choose active – they’d still on average lose to the market. But it’d be much less potentially damaging.

Slashing costs – that’s the only proper way for active to compete long-term.

Actively foolish

The industry though continues to prefer an alternative route of spreading fear and confusion to try to salt the earth for passive funds.

Just last week saw another doozy in the Financial Times.

The article – Passive Investing Is Story Up Trouble1took a machine gun to modern markets. Albeit a machine gun filled loaded ping pong balls.

The result was a lot of random seeming attacks bouncing everywhere and missing their target.

The piece attacks robot traders for their supposedly indiscriminate – or at least business-agnostic buying – before strangely conflating their activities with passive investing.

Investors in index funds and ETFs are also lamentably clueless, the author implies, pushing up the most popular stocks with their relentless buying.

Never mind that many a robot’s algorithmic strategy is focused on company fundamentals, via the factor investing I mentioned above.

And never mind that – for the gazillionth time – money that flows into the big market-cap weighted funds does not in itself distort prices. That’s not how it works!

Market cap weighted index funds follow the prices set by active investors.2

Anyway, even the allegedly witless robot traders who follow price signals are not just waving their steely fingers in their air. Prices contain information, whether it’s a shortage of cocoa that pushes up the price of chocolate bars or a surplus of some high-flying tech stock that people want to dump after a terrible trading update. A robot trader’s algorithm is not ‘think of a number between one and a hundred and pay it’.

But perhaps the biggest laugh is the implication that passive investing and automated trading has brought imminent ruin to a previously calm money-making oasis.

Stock markets boomed and blew up for a hundred years fine without index funds or robot traders. Flash crashes are dramatic and unsettling, but they last a couple of hours – manias and funks driven by human emotions can persist for decades.

If the big gains we’ve seen for US tech giants like Apple, Alphabet, and Amazon are priming the stock markets for an imminent rout (and I don’t think they are, incidentally) then it will be because active investors set too high a price for those shares – not because passive money dispassionately followed it.

And when the dust settles after the next crash – and there will be a next crash – we’ll see how well these active gurus sidestepped the alleged silliness they see today.

Perhaps a bevvy of skeptical active funds will smash the market and vindicate their high fees?

I wouldn’t hold your breath.

1. [Search result] [↩]
2. The one quirk is when a company enters or leaves an index that is being tracked, there can be a price impact from passive fund trading and those who anticipate it. But that is a one-time event, is rarely what’s being attacked, and the overall affect is relatively small. [↩]

There’s a lot of talk at Monevator Towers about investing in shares to build for your financial future.

But how do you actually go about getting started?

Back in the old days, to trade investments you might pop down to the local stockbroker on your High Street or set up a telephone brokerage account.

Nowadays though, it’s all done online.

To invest in funds1 or to buy individual stocks or investment trusts, you need to open an online broker account (also known as a platform or – less commonly – as a fund supermarket.)

It can be quite intimidating to open such an account if you’ve never done it before. But once you know what to do it’s easy.

Here’s a guide on how to set up a brokerage account.

Decide what type of account you need

There are three types of broker accounts for investors:

1. Stocks and Shares Individual Savings Accounts (S&S ISAs)
2. Self-Invested Personal Pensions (SIPPs) or other types of personal pensions
3. Trading accounts

There is little practical difference in terms of the physical mechanics of operating these accounts.

There are however a few investing differences.

The first is that both S&S ISAs and SIPPs are tax-efficient wrappers. This means that they confer tax advantages over standard share trading accounts. There are annual limits as to how much you can put into them.

The second difference is that there are slightly fewer investment options in a S&S ISA compared to a SIPP and fewer again than in a trading account.

The last difference is that money invested in a SIPP is tied up until retirement age, whereas with a S&S ISA you can move money in and out with a few limitations. You’re entirely free to move your money with a trading account (but watch out for capital gains taxes!)

Which account you need then will depend on the access you’re after, what your tax situation is and what investments you intend to make.

Generally it is always best to open a S&S ISA over a standard dealing account, at least until you start running up against the ISA contribution limits. You can read more on the pros and cons of ISAs versus SIPPs at the YoungFIGuy blog.

Find the right broker / platform

In choosing your broker you want to get the broadest investment options with the best possible customer service for the cheapest price.

In practice, there are some trade-offs.

See this beginner’s guide for what to look for when choosing a broker.

Monevator has been slaving away for several years to maintain an up-to-date comparison table for UK brokers. This compares all the charges for each broker. Loyal readers chime in with their personal experiences with the various options.

If you don’t know which broker to go for, the comparison table is a good place to start your research.

Set up an account

To set up your account you’ll need:

• Your National Insurance (NI) number
• Address details
• Bank account and debit card details
• A pen and paper

You will then need to go through the following stages.

1. Select the type of account you want to open

When you go to your chosen broker’s website, they’ll offer you those three different account options we looked at: S&S ISA, Trading Account, or a SIPP.

For example, here are the options from the broker we will use to illustrate the rest of these steps.

We’re going to run through opening a S&S ISA. There is little difference between setting up either of the three account types though, in practice.

2. Fill out your personal details

3. Decide how you want to fund your account

There are three ways to fund your account:

• Invest a lump sum – You set up the account with a one-off payment, which you can top up with more money later if you want to.

• Regular monthly savings – You create a Direct Debit to transfer a set amount each month to your account. This can often be as little as £10-£25 per month, but check with your chosen platform. It’s possible to increase the amount transferred each month after the account is set up.

• A combination of the two – Fund the account with a lump sum and top-up with regular monthly savings.

Depending on the option you chose, you’ll need to fill out either your debit card or bank account details.

4. Decide what to do with your initial money

The next step is optional at this stage. You’ll be asked if you want to immediately invest the money you’ve put into the account into a fund or shares.

The investment options available will depend on the type of account you’ve set up (ISA vs SIPP vs trading account) and what broker you have opened an account with.

If you’re not sure where to invest yet, leave it in cash for now.

If you need some help in deciding what investments to put your money into, have a look at the Slow and Steady model portfolio for inspiration.

5. Choose what happens to your distributions

Depending on what exactly you invest in, your funds or shares may pay out distributions (dividends or interest) over time. The last step is to decide what happens to these distributions.

There are typically three options:

• Keep the distribution as cash in your account
• Have distributions automatically re-invested into your investments
• Have the money paid straight into your bank account.

If you’re not sure what you want to do, choose to keep the cash in your account. You can always decide what to do later.

(There are rules around withdrawing money from and putting money into both ISAs and pensions. Make sure you know all about these restrictions before you take any money out of those accounts.)

Getting stared with your new broker account

At some point you’ll be given some log-in reference details and such like. Make sure you remember these, or you could be locked out before you begin!

You’ll then usually have to wait a few days to begin playing around with your shiny new account.

Your broker will send you some letters to you in the post. You should expect two or three letters. They’ll usually arrive within a couple of working days. (Brokers act quick when they want your money!)

The first letter will usually confirm your account number and other details and that you’ve set up an account. The second will give you a PIN or password to gain first-time access to your account. You may get a third letter if you’ve set up an ISA. This will be a copy of your ISA application form.

Once all that’s arrived you’ll be able to log into your account.

A few pointers

Once you’ve got your account set up, you should do a bit of admin to make sure things run smoothly.

Every broker account will have an account administration menu, labelled ‘my account’ or ‘account settings’ or similar. Here you’ll be able to view and update all the information and options we went through in setting up the account. It’s worth taking five minutes to make sure it’s all correct.

The next bit of admin is to find out where you can access all the documents for your account. Usually, it’s under ‘documents’ or ‘portfolio history’ or similar. Consider setting up a folder on your computer to save new documents as they come in. Good records can save a lot of hassle down the line, particularly when it comes to tax affairs.

You’ll usually receive a yearly or bi-yearly statement showing all your investments. There are various other documents to look out for over the year, too:

• If you have a SIPP you’ll receive a pension illustration – a projection of your future pension pot.

• If you have a trading account, you’ll get what’s called a Tax Certificate, which gives you the information you need for completing a Self-Assessment tax return.

• When you buy or sell an investment you’ll receive a Contract Note which sets out exactly what you’ve bought or sold, how much you paid or received, and the settlement date of the trade.

You may want to download these documents to that desktop folder you set up for safe record keeping.

When you are ready to add or withdraw money from your account, you can usually find the option to do so under ‘cash’ or ‘add/withdraw money’. This menu will also typically let you access some sort of a cash statement showing how much cash is in your account, as well as how your money has moved around as you’ve bought or sold investments, paid charges, and received distributions.

Over to you

If you have yet to set up an online brokerage account to start investing, then hopefully this guide has given you the confidence to get going.

Of course, many of Monevator readers are grizzled investing veterans. What tips or guidance would you give to somebody looking to set up their first broker account? Please share your suggestions in the comments below.

Read all The Detail Man’s posts on Monevator.

1. Variously known as Unit Trusts or Mutual Funds or Open-Ended Investment Companies, which are all basically the same thing for our purposes here. [↩]

What caught my eye this week.

The Bank of England is hellbent on crashing the economy, having recklessly raised interest rates by 0.25% to 0.75% this week.

No, that’s not my opinion. But it was a view sounded by many commentators in the wake of Bank Rate rising above 0.5% for the first time in a decade. Critics even included one former Bank Rate setter.

Really? Let’s remember that with inflation running at well over 2%, we still have a strongly negative real interest rate. (‘Real’ means inflation-adjusted, remember).

Even after this latest rise, the real Bank Rate is still MINUS 1.55%.

And that’s before we take into account the impact of all those rounds of quantitative easing, the point of which was to effectively lower real interest rates in the market.

Money remains historically very cheap.

Borrowers still blessed

It’s true that several million people on variable rate, tracker, and discount mortgages will see their monthly payments inch up a tad.

But many such homeowners have seen their mortgages being paid off by a decade of negative interest rates. For all the austerity felt by the poor, it’s been a super time to be a middle-class homeowner. Few should complain too loudly about a 0.25% rate rise.

On the flip side, some of the rate rise will be passed on to savers, though as we slowly return to something like normal rates we should expect this to lag.

UK banks never took the interest rates paid to ordinary savers below 0% in the financial crisis. Instead there was a compression of the spread of rates that banks usually profit from. This will have to be unwound, and so I expect savings rates to rise more slowly than mortgage rates.

I’m inclined to think that if the economy cannot take a slightly less negative real interest rate – fully ten years after the financial crisis and with employment and with house prices at an all-time high – then we ought to find out sooner rather than later, as opposed to speculating.

Star power

With the rate rise expected by everyone, perhaps the more interesting thing to come out of the Bank was an estimate what its wonks call r*. (Pronounced “r-star”).

r* is shorthand for the ‘equilibrium real interest rate’ – and if you think that mouthful is reason enough for the shorthand, wait until you hear the long definition:

The ‘equilibrium interest rate’ is the interest rate that, if the economy starts from a position with no output gap and inflation at the target, would sustain output at potential and inflation at the target.

Okay, perhaps that’s not too confusing. But then I have been reading the Bank’s deliberations for the past couple of hours, so perhaps I’m inured to banker-speak.

You can get up-to-speed on r* for yourself by reading pages 39-43 of the newly-published Inflation Report [PDF].

Basically r* is the Goldilocks interest rate – neither too hot (that is, a rate that’s too low) to stoke the economy and push up inflation, nor too cold (er, a rate that’s too temptingly high) to incentivize savers to move their money out to work fueling the engines of capitalism, as opposed to leaving it all sitting in a bank in cash.

Unfortunately, there’s no way of knowing exactly what r* is at any particular time.

Instead, policymakers have to infer it, in the same way that you have to try to figure out if he or she is really in love with you.

Various factors may weigh down – or boost – the equilibrium real interest rate. In the medium to long-term though there’s presumed to be an underlying trend rate – confusingly also called R*, though note the capital – which is where real interest rates could sit if the economy never fluctuated and Bank officials could spend their time at the beach instead.

Sadly in the real world, things do impact the rate – an impact that the Bank labels s* (where the ‘s’ supposedly stands for short-term but which I think stands for shit stuff happens.)

When s* would heat things up, r* would need to be higher than it otherwise would be (R*).

When s* is a drag, r* would need to be lower.

Right now the Bank believes we’re still in a sticky patch for ‘stuff happening’, what with the Brexit uncertainty, talk of trade wars, the lingering impact of the financial crisis, and also perhaps rates around the developed world being similarly measly.

This belief that r* is low is why Carney and Co. have been keeping Bank Rate so low, and why the Bank is raising rates so slowly.

The Bank’s assessment is that R* would be too high a Bank Rate to keep inflation on target at 2%, given the headwinds.

It believes r* is lower, and hence we still get low interest rates.

R-stars in their eyes

If you’re not asleep by now, no doubt you’re screaming: “Great, but what should R* be! Surely that’s the important bit!”

You’re right, like the Bank of England I’ve deliberately buried the lead.

After stressing that its best guess is just that, the Bank estimates that R* – the long-term trend real equilibrium rate, you’ll recall – is currently somewhere between 0%-1%.

What’s more, it estimates R* has plunged from around 2.25%-3.25% back in 1990!

This is all hugely significant.

Remember, R* is a real interest rate. Add the 2% inflation target onto it, and we get to where the Bank Rate would be in a perfect world (to over-simplify).

What the Bank is estimating is that absent those short-term / stuff happens factors, Bank Rate would now be at between 2-3% (as opposed to 0.75%).

In contrast, if R* was still where it was in 1990, the equivalent ‘normal’ Bank Rate would be 4.25-5.25%.

Clearly this has big implications for both savers and borrowers.

It suggests anyone waiting to get 5% – or even 3% – in a standard savings account shouldn’t hold their breath.

Similarly, mortgage holders shouldn’t have too many sleepless nights worrying about rates leaping back up to 5-7%, at least on current forecasts.

Playing for ratings

Of course if R* can come down then it can go up again.

The Bank thinks that the aging population, slower productivity growth, and the impact of more cautious financial regulation has likely pulled down R*.

Set against that, it believes the requirements of younger foreign savers and even the rise of the robots could affect R* in the future.

But it doesn’t expect anything to happen very quickly, to either r* or R*.

Absent some huge shock such as a Hard Brexit or a surprise election-related run on the pound, the bottom line is interest rates aren’t going much higher anytime soon.

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