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The battle to woo investors to index funds is heating up, with some marketing strategies shifting to no-fee from low-fee.

Boston-based Fidelity Investments Inc. has raised eyebrows in recent months by offering four no-fee index mutual funds to residents of the United States. While it is unclear how widespread “free” will become, the pressure to cut costs on mutual and exchange-traded funds (ETFs) is growing, industry experts say.

The Fidelity move “signals that there is and will continue to be some level of price competition,” says Dan Hallett, director of asset management at Oakville, Ont.-based HighView Financial Group. “But we are never going to get to truly zero fees because it is a matter of trade-offs. … There is always a catch.”

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For Fidelity, which sells mutual funds and ETFs and owns a brokerage firm, “it’s a loss leader,” says Mr. Hallett, referring to a strategy where a product is sold below cost to get customers in the door. “They are able to do it because the funds are offered strictly on their brokerage platform, which they don’t have in Canada.”

U.S. investors drawn to Fidelity’s zero-fee funds could end up buying other Fidelity mutual funds or ETFs, or trade through its brokerage, he says. “There is an expectation that the revenue is going to be made up in other ways.”

Fund companies are engaging in a race to the bottom on fees.

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The no-fee marketing angle has made its way to Canada, too. Toronto-based Horizons ETFs Management (Canada) Inc. last summer launched what it billed as Canada’s first zero-per-cent management-fee ETFs. It was for two global balanced-fund offerings that invest in other Horizons stock-and-bond ETFs.

Boasting about zero-fees was misleading, says Mr. Hallett. “It gave the impression that they were no-fee products … but they are not free.”

While investors don’t pay the top-line cost for the Horizons Conservative TRI (HCON) and Horizons Balanced TRI (HBAL) ETFs, they are charged fees for the underlying ETFs. Their management expense ratios (MERs) should not exceed 0.17 or 0.18 per cent, Horizons says.

Still, some ETFs are charging nearly-zero fees in Canada. It was Horizons that kick-started the price war in Canada in 2010 by introducing its low-fee Horizons S&P/TSX 60 Index ETF (HXT), he says. This ETF provides the return of the 60 largest companies on the Toronto Stock Exchange.

This offering, which uses a financial instrument called a total return swap to deliver the index return, was the cheapest Canadian equity ETF then with a MER of 0.08 per cent. (Since then, the MER has gone through various downward tweaks.) It is Canada’s lowest-cost ETF today because it cut its MER to 0.03 per cent after rebating 0.04 per cent of the management fee to unit holders.

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The fee war really accelerated after U.S.-based fund giant Vanguard Group Inc. – a champion of low-cost index funds – entered the Canadian market in 2011, says Daniel Straus, an ETF analyst at National Bank Financial Inc.

Now, several ETFs give broad exposure to the Canadian market for a low MER of 0.06 per cent. They include Vanguard FTSE Canada Index ETF (VCE), Vanguard FTSE Canada All Cap ETF (VCN), BMO S&P/TSX Capped Composite ETF (ZCN) and iShares Core S&P/TSX Capped Composite ETF (XIC).

But some of Vanguard’s U.S.-listed ETFs can effectively have zero fees in certain years if the funds earn enough revenue from securities lending to compensate for the MER, says Mr. Straus. Like its peers, Vanguard can make money lending some high-demand shares to short sellers who want to bet against those stocks.

While U.S. ETFs and mutual funds engage in this activity, the impact is more noticeable with ETFs because they charge lower fees, he says. Fund companies differ on the profit-sharing arrangements, but Vanguard says it gives 100 per cent of the net revenue from securities lending back to an ETF’s unit holders.

Because the Canadian ETF market is much smaller than in the United States, there is less opportunity in having side businesses, such as securities lending, to offset management fees, Mr. Straus notes.

While Canadian banks could offer zero-fee funds since they have revenue sources from their brokerages and other investment products, “I would judge it unlikely” given the market size, he says. “But I would never say never.”

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In the U.S. market, competition is so fierce that a fraction of a fee could be shaved in the bid to be cheaper, Mr. Straus says. For instance, New York-based ETF provider GraniteShares recently cut the MER on its U.S.-listed GraniteShares Gold Trust ETF (BAR) to 0.1749 per cent from 0.20 per cent.

That makes this gold fund cheaper than its nearest rival, SPDR Gold MiniShares Trust ETF (GLDM), which launched in June with a MER of 0.18 per cent. “By doing so, BAR could be rounded down to 0.17 per cent,” so that GraniteShares could say it has the cheapest gold ETF, says Mr. Straus. “That’s marketing.”

The pressure to slash fees also has ETF providers shopping for cheaper indexes. In 2012, Vanguard moved some North American fund offerings away from benchmarks provided by MSCI Inc. to FTSE Russell and the University of Chicago’s Center for Research in Security Prices. In Canada, Horizons and BMO Asset Management Inc. have embraced some indexes from Germany-based Solactive AG.

But ETF providers are also producing indexes in-house or use a proprietary methodology for their funds instead of licensing benchmarks from a third party, says Mr. Straus. “Both ways would let you cut costs.”

John Hood, president of Pickering, Ont.-based J.C. Hood Investment Counsel Inc., says there is a “race to the bottom going on,” but stresses that the absolute lowest fee should not be the deciding factor when investing in ETFs.

For instance, Horizons charges a slightly lower fee for its global balanced ETFs than similar funds from Vanguard Canada. Both offer a “one-ticket solution to investing,” but there are significant differences, too, says Mr. Hood.

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The Vanguard ETFs, which will hold the securities directly, also pays out distributions to unit holders. The swap-based Horizons ETFs don’t pay out distributions – as they are reinvested – so investors need only to pay tax on capital gains if held in a non-registered account.

The Vanguard ETFs would appeal to more of “my clients who are older and are approaching retirement,” he says. “They want the income from their portfolios.”

If the fee difference is between 0.05 per cent and 0.10 per cent, “I don’t really care that much … as long as it is cheap,” says Mr. Hood. “You have to know what is in the guts of the ETF. What I care about is whether it does what I want it to do.”

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