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Index Funds Fight Back Against ETF Rivals

Thursday - 12/13/2012, 6:09pm  ET

Ordinary investors have flocked to exchange-traded funds over the past several years, as their low costs and easy access have been especially attractive in comparison to alternatives like mutual funds. But the highly lucrative mutual fund business isn't going to go down without a fight, and earlier this week, Fidelity fired yet another shot in what could become a knock-down, drag-out war between the mutual fund industry and ETF providers.

Later in this article, I'll reveal what Fidelity did to make index funds more competitive. But first, let's take a look at the battleground between funds and ETFs to discover what's at stake in this budding price war.

How ETFs have trumped index funds
For decades, index mutual funds were innovators in a well-entrenched industry of actively managed fund counterparts. Index funds provided huge cost savings versus active funds, which typically charged an extra percentage point in expenses each and every year. Over an investor's lifetime, the fees on active funds added up to a serious shortfall compared to what you could have achieved from using index funds.

But as Fool analyst Alex Pape observed in far more depth a few months ago, ETFs have proven their superiority over index funds in many ways. Here are just a few.

  • ETFs are more flexible, as they're easily purchased no matter what broker you do business with and are readily transferable across accounts through established transfer protocols. You can also buy and sell ETFs at any time during the trading day, rather than having to wait until market close and to get orders in by specific deadlines.
  • ETFs carry tax advantages over index funds. Because of the way that ETFs create and redeem large blocks of shares, most equity-oriented ETFs are able to avoid making taxable distributions of capital gains entirely. That's not true for all index funds, which have to rely on being able to sell high-cost shares to avoid generating gains that they would have to distribute to shareholders.
  • The lowest-cost ETFs have fees below what the lowest-cost index funds charge.
  • The breadth of index ETFs is far greater than for index mutual funds. Most index funds focus on large market indexes, while ETFs have been more than willing to embrace new concepts and develop indexes to track previously uncovered niches of the market.

As a result, index ETFs have been consistently drawing money away from mutual funds. That's been incredibly good news for BlackRock , State Street , and other ETF providers that don't have a big mutual fund presence. It's bad news for Franklin Templeton , Goldman Sachs , and other companies that have extensive mutual fund offerings but no ETFs. And for Fidelity, which lacks an extensive ETF line of its own to push customers toward, it's a major threat.

What Fidelity did
Fidelity's move involves cutting fees on eight of its Spartan index funds as of Jan. 1. Six of those funds own regular equities, including three stock funds aimed at large-cap, mid-cap, and small-cap stocks respectively as well as a total market fund, a global fund, and an emerging markets fund .

In addition, Fidelity lowered minimum investments on some of its cheaper share classes. With many funds, lower fees will become available at balances as low as $10,000, a stark reduction from the former $100,000 minimums that applied previously.

Will it work?
Fidelity's actions are a positive sign of the extension of the fee war among ETF providers into the mutual fund realm and will keep index funds competitive with some ETF products. For instance, in the emerging markets realm, the fee cut will draw Fidelity's Advantage class even with Vanguard Emerging Markets .

More broadly, though, it's unclear what impact these small moves will have on Fidelity's popularity. The fund company's press release listed workplace retirement plan sponsors first and individual investors second, making clear that big institutions are the true force driving the cuts.

The popularity of ETFs has made them an almost unstoppable force. Minor fee drops aren't going to stop that trend. At this point, it would likely take almost a flash crash-level event to dissuade investors from increasingly incorporating ETFs into their portfolios.

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This article was originally published as Index Funds Fight Back Against ETF Rivalson Fool.com

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