Zero-Fee Index Funds

Quick definition: Index funds with zero expense ratio, made possible by brokers subsidizing the funds through alternative revenue streams like share lending, commission rebates, or using the funds as loss leaders to attract customers for other services.

Key Takeaways

• Zero-fee index funds are economically viable because operating an index fund has marginal cost approaching zero—the hard work is one-time infrastructure investment
• Brokers offer free funds to attract customers and retain assets, generating revenue through trading commissions, lending out shares, or selling other products
• The quality of a zero-fee index fund can vary substantially depending on the fund operator; some are genuinely excellent while others have tracking error or other hidden costs
• For most investors, a zero-fee index fund is preferable to a 0.03% index fund simply because the fee advantage, though seemingly small, compounds to substantial wealth differences
• The emergence of zero-fee options represents the endpoint of an industry-wide shift toward index investing and away from profitable fee-based active management

The Possibility of Free Index Funds

The idea that you can own a diversified portfolio of index funds with literally zero fees might seem impossible. How does a fund company operate a fund without charging customers? Who pays the salary of the fund's staff? Who maintains the systems that track billions in assets?

The answer lies in understanding the economics of scale in index fund operation. Once a firm has built the infrastructure to operate an index fund—the trading systems, the compliance monitoring, the record-keeping—the marginal cost of adding more customers is negligible. A fund that holds $100 billion in assets costs almost exactly as much to run as a fund that holds $100 billion plus one additional share.

Compare this to active management, where each additional dollar often requires additional investment in research, traders, or systems. A portfolio manager overseeing $1 billion in assets has a different job than one overseeing $2 billion. The talent is more stretched. The trading becomes more complicated. The costs are incremental, not fixed.

Index funds are the opposite. The incremental cost of one more customer is essentially zero. The firm is replicating a mechanical index, not employing expensive talent. Once the system is built and working, serving more customers requires marginal additional expense.

This creates an unusual business dynamic. As index fund fees have fallen toward zero, firms have found ways to operate them profitably by looking for revenue elsewhere. The fund itself can be free, but the broader customer relationship can be profitable.

How Brokers Make Money on Zero-Fee Funds

Modern brokers make money on zero-fee funds through several mechanisms, none of which are hidden or underhanded, though investors should understand them.

Share lending: When you own shares in a brokerage account, the broker can lend those shares to short-sellers and earn a fee. For stocks with high short interest, this can be meaningful revenue. For broad index funds, the revenue is typically small, but it contributes. The zero-fee fund holder bears no cost from this; the broker simply uses the shares for additional revenue.

Trading commissions: Many zero-fee index funds are offered through brokers that also execute trades. When you buy individual stocks or trade options or currencies, the broker earns commissions. The zero-fee index fund is the vehicle that brings you in the door. Once you're a customer, there are numerous opportunities for the broker to earn revenue from other activity.

Asset management fees on other products: A customer who has a zero-fee S&P 500 index fund with your brokerage might also purchase a bond fund (with a fee), use a robo-advisor service (with a fee), or hold other accounts with the firm. The zero-fee fund is part of a portfolio of services, not necessarily profitable on its own.

Cross-selling: Some investors with index funds eventually decide they want advice and pay for financial advisory services. Some are sold on other services—checking accounts, lending products, estate planning—that generate revenue for the financial institution.

Float: Some brokers earn interest on uninvested cash sitting in accounts. If your dividend gets paid into a money market account at the broker, the broker earns the interest on that money.

None of these mechanisms are problematic or underhanded. They're the natural business model of a financial institution. The insight is that a single product (the zero-fee index fund) doesn't need to be profitable on its own if it's part of a profitable relationship.

The Quality Question

Not all zero-fee index funds are identical. Some are genuinely excellent—they track the index closely, have minimal trading costs, and are operated by reputable firms with long-term commitment to index investing.

Others might be lower quality. A startup offering a zero-fee fund might have poor tracking error—it might not follow the index precisely due to inefficient execution or sampling errors. Or it might operate without sufficient scale, making the economics unsustainable long-term. Or it might be an attempt to harvest data or mining customer information.

The major brokers—Vanguard, Fidelity, Schwab, Charles Schwab—offer high-quality zero-fee or near-zero-fee index funds because they're established, reputable firms with deep expertise in index investing. The risk that they'll abruptly shut down the fund or degrade its quality is very low.

Smaller brokers or startups offering zero-fee funds should be evaluated more carefully. What's their revenue model? Is it sustainable? What's the tracking error? How long have they been operating? Is the fund likely to be around in 20 years?

Comparing Zero-Fee to Near-Zero-Fee Options

In practice, the choice for most investors is between zero-fee funds and near-zero-fee funds (0.01% to 0.05%). The mathematical difference between zero and 0.03% is not enormous over time scales shorter than a decade.

Starting with $100,000 at a 7% pre-tax return over 30 years:

• At 0.00% fees: $761,000
• At 0.03% fees: $754,000

The difference is about $7,000, or less than 1% of the final balance. For most investors, this is not a decisive factor. If a zero-fee option is available from a reputable source with good tracking, take it. If not, a 0.03% alternative is not meaningfully worse.

What matters vastly more is the difference between a 0.03% index fund and a 1% active fund. That difference, compounded over 30 years, is hundreds of thousands of dollars. The choice between zero and near-zero fees is a rounding error compared to the choice between passive and active.

The Sustainability Question

A reasonable concern about zero-fee funds is whether they're sustainable. Can a brokerage really operate index funds with zero fees indefinitely?

The answer depends on the specific situation. For a large, diversified brokerage making money from many sources, zero-fee index funds are sustainable. They're a loss leader on the fund itself, but they're profitable when viewed as part of the customer relationship.

For a firm that offers only index funds and has no other revenue source, zero fees are unsustainable. But such a firm is unlikely to emerge—the competitive advantages are all with diversified financial institutions that can cross-sell services.

There's always a risk that a firm could reverse course, raising fees on existing customers (though this would be unpopular and might trigger outflows) or discontinuing the zero-fee option. But this risk is low for established brokers with reputations to protect.

The Endgame of Fee Compression

The emergence of zero-fee index funds represents the logical endpoint of the 50-year trend of fee compression. When the marginal cost of operating an index fund reaches zero, competition should drive prices toward zero. The fact that some brokers have reached this point suggests that the competitive pressure is working.

It also suggests something important about the index fund industry: the real competition is no longer among index fund providers, it's among the brokers and financial institutions that bundle those funds with other services. The index fund itself has become a commodity product, as frictionless and free as the underlying market information that drives it.

For investors, this is the ultimate victory. Your mutual fund fees have declined from 0.83% to zero—not because of charity, but because the economics of the business model finally reached the point where that was the only competitive option.

Decision flow

Next

In the final article of this chapter, we address the opposite question: given that index funds are so efficient and low-cost, when do they fail? What are the limits and edge cases where index funds don't work and investors need to think harder?