How Do Vanguard, Fidelity, and Schwab Make Money Offering Low Expense Ratio Index Funds? - The Wall Street Physician (2024)

People have been marveling at how Fidelity is able to offer two index funds (FZROX, FZILX) with zero expense ratios to their investors.

There’s something powerful about getting anything for free, but the ability to have someone give you diversification to nearly the entire U.S. stock market in a single fund for free is truly remarkable.

However, few things in life are ever truly free, and I would hardly expect a financial services company to give anything for free without something in return.

Fidelity has clearly made a calculated decision that it can make money by offering zero expense ratio mutual funds. Since it does not charge investors any management fees, they aren’t making money from actually managing the fund. It is clearly a loss leader, and Fidelity will need to make money by other means.

Vanguard and Schwab are also offering index funds to investors at razor-thin margins. Yet each of these companies are thriving despite massive decreases in their index fund management fees over the past few years.

All of this begs the question: How can these companies expect to make money offering index funds for less than $1 in management fees per $1,000 invested?

Vanguard, Fidelity, and Schwab Are Not Charities

Despite offering the tremendous service of index fund investing at low to zero cost, Vanguard, Fidelity, and Schwab are hardly on shaky financial ground.

Quite the opposite — they are making billions of dollars per year from investors.

2017 Profits for Fidelity and Schwab

Fidelity Investments, a privately held company, made $5.3 billion dollars in 2017. They were able to do this by managing over $2.45 trillion dollars.

Charles Schwab (SCHW), a publicly traded company, made $2.4 billion dollars in 2017 on revenue of $8.6 billion and assets under management of $3.36 trillion dollars. This was a 25% increase from 2016, and the company is currently worth over $68 billion dollars.

Vanguard is privately held and does not report their revenues or earnings, but given that they currently manage over $5.1 trillion dollars, it’s very likely that they make multiple billions of dollars a year as well. They do not have direct shareholders, stating that they use their profits to drive down the costs of their mutual funds.

A back-of-the-envelope calculation of Fidelity’s operating margin shows that Fidelity turns a profit of 0.22% of assets under management ($5.3 billion dollars in profit divided by $2.45 trillion dollars of assets).

While Fidelity was a market leader in actively-managed mutual funds, they are now firmly in the index fund camp, especially with the introduction of zero-expense ratio index funds. They are clearly trying to acquire assets under management to make money through other methods.

How Does Schwab Make Money? Just Look At Their Financial Reports!

While Fidelity and Vanguard are privately held and do not release the details of how they make money, their competitor Schwab is a publicly traded company (ticker symbol SCHW) that produces detailed financial reports for their stockholders on a quarterly basis.

In these reports, we can glean how Schwab make money. We can assume that Fidelity and Vanguard are using similar business models to make money.

Each year, Schwab (and every other public company) releases a Form 10-K statement, which is publicly available on the SEC.gov website.

Looking at Schwab’s 2017 10-K statement, here’s how their profits broke down by revenue source:

As you can see, only 24% of Schwab’s profit comes from mutual fund and ETF service fees.

The largest source of revenue for Schwab is actually “net interest income.” This was very surprising to me, and perhaps it is surprising to most investors. Most people probably think that Schwab makes most of their money on management fees for their mutual funds and ETFs (24% of profit), financial advisory fees (12%), or commissions (7%).

The biggest source of revenue for Schwab? Mutual fund management fees? Financial advisory fees? Commissions? No, it's net interest income -- making money on your uninvested cash. Click To Tweet

Net interest income is also how Etrade makes the majority of its revenue.

What exactly is net interest income?

Etrade states that “net operating interest income is earned primarily through investing deposits and customer payables in assets including: available-for-sale securities, held-to-maturity securities, margin receivables and real estate loans.”

In plain English, they take customer deposits (most often cash) and invest it. Essentially, they are using the uninvested cash sitting in your account earning minimal interest and investing it at a higher interest rate to make money.

So my interpretation of the 10-Ks of Schwab and Etrade is that brokerages are doing whatever it takes to acquire as many assets under management as possible, with the hope that some of the money goes uninvested, which they can use to earn interest.

This is why the Fidelity ZERO index funds are only available to Fidelity customers; they want you to bring your money under their umbrella. Sure, they want you to consider investing in actively-managed mutual funds, or use their advisory solutions. If you do some trading, of course they want to be the ones collecting $7.95 commissions. But at least based on Schwab and Etrade’s publicly traded documentation, Fidelity most wants you to keep some of your money in cash with them so that they can earn interest on it.

If you can make money offering free trades, you can make money offering zero-fee index funds

Fidelity is not the first company to offer a free service in order to acquire assets and earn interest income. This is precisely the business model of some of the startups that are offering commission-free trading for all stocks such as M1 Finance and Robinhood.

By offering commission-free trading, these startups want to acquire assets under management, helping them earn money through net interest income from cash deposits. Sure, they offer premium services such as Robinhood Gold, but what they’re really after is your uninvested cash.

Conclusion

Fidelity shocked the investment world when they began offering zero expense ratio mutual funds to investors. In my opinion, they are doing this in order to bring investors under the Fidelity umbrella. Based on the revenue models of their publicly traded competitors, Fidelity will try to make money on investors in their zero expense ratio funds by earning interest on their uninvested cash, rather than trying to upsell an index investor into actively-managed funds or financial advisory services.

What do you think? How do you think Fidelity will make money by offering a zero expense ratio mutual fund? Were you surprised that commissions and financial advisory services make up only a minority of Schwab and Etrade’s profits?