Another ploy most mutual fund companies use, including Vanguard, is soft dollar arrangements with brokers. In these arrangements, fund companies pay a higher commission to brokers to execute transactions than would normally be charged just to execute the requested trade. In return for the extra cost, the brokers supply services, data, research reports, sometimes even computer hardware, various other things. That the fund may do this will be described in the so-called Statement of Additional Information. The text therein will point out that the goods and services received are commensurate in value with the extra cost paid in the commissions.
But the goods and services received are used to administer the fund. For mutual funds with non-zero expense ratios, having some of the administration costs covered by these extra paddings in the transaction costs means that these costs are not accounted for in the expense ratio of the fund, so that the fund company can advertise a lower expense ratio and/or book more profit from the expense ratio charged off to the fund.
In the case of a Fidelity Zero fund, where there is no expense ratio, it would mean that some or all of the administrative costs are being charged to the fund through padding of the transaction costs. However, it would be unlikely that all of the administrative cost could be covered this way, much less a profit, unless the fund were paying for services for other Fidelity mutual funds through padding of the transaction cost.
I looked at the Statement of Additional Information for FZROX, the Fidelity Total US Stock MarketIndex fund purported to have zero cost, and low and behold, paying costs associated with other funds by the assets in FZROX through padded broker commissions that receive goods or services used to administer those other funds is contractually allowed in the Statement of Additional Information. Here is some text extracted from there with some relevant text highlighted in red:
So it seems that Fidelity can hide the expense ratio for the zero funds by paying extra transaction costs to brokers to receive goods and services back, not only for the administration of the zero fund but for other funds you may never have even heard of, much less invested in. This lack of transparency makes it extremely difficult to know what the de fact expense ratio of a so-call zero fund might be, but my opinion is that you can rest assured that it is not zero.The Acquisition of Brokerage and Research Products and Services
Brokers (who are not affiliates of FMRC) that execute transactions for a fund may receive higher compensation from the fund than other brokers might have charged the fund, in recognition of the value of the brokerage or research products and services they provide to Geode.
Research Products and Services. These products and services may include, when permissible under applicable law: economic, industry, company, municipal, sovereign (U.S. and non-U.S.), legal, or political research reports; market color; company meeting facilitation; compilation of securities prices, earnings, dividends and similar data; quotation services, data, information and other services; analytical computer software and services; and investment recommendations. In addition to receiving brokerage and research products and services via written reports and computer-delivered services, such reports may also be provided by telephone and in person meetings with securities analysts, corporate and industry spokespersons, economists, academicians and government representatives and others with relevant professional expertise. Geode may request that a broker provide a specific proprietary or third-party product or service. Some of these products and services supplement Geode's own research activities in providing investment advice to the funds.
Execution Services. In addition, products and services may include, when permissible under applicable law, those that assist in the execution, clearing, and settlement of securities transactions, as well as other incidental functions (including, but not limited to, communication services related to trade execution, order routing and algorithmic trading, post-trade matching, exchange of messages among brokers or dealers, custodians and institutions, and the use of electronic confirmation and affirmation of institutional trades).
Mixed-Use Products and Services. Geode may use commission dollars to obtain certain products or services that are not used exclusively in Geode's investment decision-making process (mixed-use products or services). In those circumstances, Geode will make a good faith judgment to evaluate the various benefits and uses to which they intend to put the mixed-use product or service, and will pay for that portion of the mixed-use product or service that does not qualify as brokerage and research products and services with their own resources (referred to as "hard dollars").
Benefit to Geode. Geode's expenses would likely be increased if it attempted to generate these additional products and services through its own efforts, or if it paid for these products or services itself. Certain of the brokerage and research products and services Geode receives are furnished by brokers on their own initiative, either in connection with a particular transaction or as part of their overall services. Some of these products or services may not have an explicit cost associated with such product or service.
Geode's Decision-Making Process. Before causing a fund to pay a particular level of compensation, Geode will make a good faith determination that the compensation is reasonable in relation to the value of the brokerage and/or research products and services provided to Geode, viewed in terms of the particular transaction for the fund or Geode's overall responsibilities to the fund or other investment companies and investment accounts. While Geode may take into account the brokerage and/or research products and services provided by a broker in determining whether compensation paid is reasonable, neither Geode nor the funds incurs an obligation to any broker, dealer, or third party to pay for any product or service (or portion thereof) by generating a specific amount of compensation or otherwise. Typically, these products and services assist Geode in terms of its overall investment responsibilities to a fund and other investment companies and investment accounts; however, each product or service received may not benefit the fund. Certain funds or investment accounts may use brokerage commissions to acquire brokerage and research products and services that may also benefit other funds or accounts managed by Geode.