“Nothin’ From Nothin’ Leaves Nothin’”
                        -Billy Preston

In the ongoing fee wars between major financial institutions, one of the biggest has recently debuted some index investments with zero expenses, nothing, zip, nada. How can a company offer something to the public and not charge anything? In your life experience when something has been offered for free has there ever not been a catch? Let’s dig into how these large financial institutions really make their money off their index investments so you better understand how this whole system works. 

The company that recently went to a zero fee seems to be offering this service as a lost leader – that is a free service in hopes of getting paid services from clients they never otherwise would have gotten. We see this often in the world of tax preparation companies. They tell you they’ll do your taxes for free, but if you have anything more complicated than a 1040 EZ they will charge you – and you’ve already made an appointment and have all your stuff – and don’t get me started on the scam that is refund advances. But on to our main subject: In order to get this “free” investment you can’t just buy it through any brokerage, you have to have a direct account with the given investment company. Once your money is there, I’m sure they are going to encourage you to diversify from just those one or two investments you can get for free – and they have a financial incentive to get you to do so as opposed to if they were making the same amount of money regardless of what investment you are in. They can even make extra money off your free investment if you simply have some of your money in cash. All financial institutions that have any kind of fixed money type instruments, from a savings account to CDs, make their money from the spread between what they pay you and what they earn on your money. So even if you open an account to get the “free” investment and then leave a couple hundred thousand in cash – the investment company could very well be making more money on the spread in your cash account then they would make in another investment. Most index investments, even the ones that aren’t “free” have internal costs of 0.10% or less, so you pay them at most $1 for every $1,000 deposited. The spread on a cash account, even though there is no “fee” on the account, between what you are credited and the financial institution collects can be easily 0.5% or more – that would be $5 per $1,000.

There is also a little secret built into almost every index investment, in fact almost every pooled investment out there, that secret is securities lending. If you want to sell a stock short, you have to either own that stock or be able to borrow it. If you don’t have access to the stock you want to short that is called “naked short selling” and that practice was effectively banned by regulations passed after the financial crisis. Because index investments own all the stocks in their index they are a convenient place for the active traders who are selling short, or working with puts and calls, to borrow shares. The SEC puts limits on how much of an investment can be loaned out and how much collateral the borrower has to put up to cover their loan, but within those parameters the individual investment company can make more conservative or more risky decisions, and of course they get to decide what to do with the money earned.  Let me give you an example. So a short seller needs 100,000 shares of ABC to cover a short position, they go to an index investment company and ask to borrow those shares, which for the sake of argument trade at $117 / share. So the investment company loans them the shares at 3% (annual) interest and makes them put up 102% collateral – in the form of cash. So the borrower deposits in this case $11,934,000 into an interest baring account with the lender. Thirty days later the borrower returns the shares, or they complete the short sale and pay off the loan. Either way the lender charged them about $30,000 in interest and also received let’s say $12,000 of interest earned on the cash that was deposited. But here’s where things get complicated. The rules on securities lending are pretty strict and it’s unlikely an investment would see any negative consequences of such lending – however in a financial crisis like 2008 when perhaps the borrower goes bankrupt before they return the stock or the “safe” investment where you deposit the collateral drops in value there are circumstances where it could affect the shareholders. That is why investments that allow less borrowing, and require higher collateral will be marginally safer than those with looser guidelines (within the fairly strict SEC limits of course.) The biggest issue with securities lending however is; what do they do with the money they earn? Many investment companies credit the index investment with all the money earned, the interest on the loan and the interest earned on the collateral. Some companies do a split between the parent company and the shareholders, still others credit the loan interest but not the collateral interest, or vice versa. Some credit the investment with all the proceeds, but since they deposit the collateral into their own cash accounts they keep the same spread on the interest rate they get from any other depositor – and if they have more money in index investments because they charge very low or zero fees, then they have more to lend, which gets them more collateral deposits, which makes the parent company that much more money on the spread between what they pay the “shareholder” of the cash fund and what they really earn on those underlying investments. 

The recently deceased John Bogle, founder of Vanguard, revolutionized low cost index investing and did help bring the costs of investments down, but he also passed away with a net worth estimated at $80 Billion. Abigail Johnson, the CEO and largest shareholder of Fidelity, the company her grandfather founded, is the richest person in Massachusetts with an estimated net worth in excess of $16 Billion. These folks didn’t get rich by giving stuff away. There is a catch to every free lunch. What we have always tried to do at Keeling Financial is charge a fee that is fair, but also even. So we have no financial incentive to move you from one thing to another, as much as possible we sit with you on the same side of the table, as your assets grow so does our compensation. As costs in the marketplace have gone down, so have our fees. I did a little digging and the total fees being charged to one of our biggest clients back in 2002 were significantly higher what we charge on even the smallest account today. We hope to continue to be able to lower our fees as times goes on, but it will never be zero. I don’t know which expression is older: “there’s no such thing as a free lunch” or “you get what you pay for” but both apply in this case. Not only do the fees our clients pay cover the costs of the investment management, but we also help with retirement, estate, long-term illness, college education, tax and budget planning all under that one fee we charge our money management clients. You also get a real person on the phone when you call who knows you by name, not by the account number you had to scream into the phone at the beep. We don’t believe the only measure of value is price, but everyone reading this of course already knows that. As always, we’re honored to get your referrals and are available if you need us.