Fidelity Investments, the asset manager that watched from the sidelines as exchange-traded funds went from zero to $1.5 trillion over the past 20 years, is finally preparing to jump into the business, according to a person familiar with the matter.
Fidelity, based in Boston, aims to become the first major mutual-fund company to introduce ETFs run by active stock pickers by opening a series of products based on its “Select” line of industry-focused equity funds, said the person, who asked not to be named because the plan isn’t public. The Denver- based unit that would run the ETFs is headed by Anthony Rochte, who was hired from State Street Corp. (STT:US) in March, the person said.
“Fidelity has the ingredients to make actively managed ETFs successful,” Paul Justice, director of ETF research in North America for Morningstar Inc. in Chicago, said in a telephone interview. “They have a household name, a distribution machine and a history of outperformance with the sector funds.”
Fidelity, the almost 70-year-old firm led by Edward C. Johnson III known for such industry innovations as direct sales to individual investors and income-oriented stock funds, trails rivals in entering the ETF business. State Street Corp. runs the oldest U.S. ETF, opened in 1993, and Vanguard Group Inc., known for its low-cost index funds, entered the market in 2001. BlackRock (BLK:US) Inc., the world’s biggest money manager, joined the fray when it purchased the iShares ETF business in 2009.
“At this time we’re not focused on specific products, but rather on how we can best position Fidelity to further develop its sector-investing capabilities in a manner that best meets the needs of our clients,” Vincent Loporchio, a spokesman, said in a telephone interview.
Bill Gross in March became the most prominent manager to open an actively managed ETF, the Pimco Total Return Exchange- Traded Fund. Its success in gathering $2.3 billion in assets has paved the way for other firms to follow suit.
Almost all ETFs track indexes tied to benchmarks, appealing to investors because of their trading flexibility and lower costs. ETFs attracted $118 billion in assets last year, according to the Investment Company Institute. Actively managed ETFs in the U.S. account for $8.8 billion, or less than 1 percent of assets held by exchange-traded products, including exchange-traded notes, trusts and commodity pools, according to data compiled by Bloomberg.
Fidelity would join a growing number of active managers looking to create ETF versions of their mutual funds as they try to reverse redemptions from traditional mutual funds. Actively managed mutual funds lost $31 billion to withdrawals last year, according to the Washington-based ICI. Fidelity’s mutual funds in the U.S. had $19.7 billion in withdrawals in the 12 months ended June 30, according to Morningstar.
Fidelity’s entry “would make others contemplating when and if to get into ETFs to think now is the time,” Deborah Fuhr, the former head of BlackRock’s ETF research who now leads London-based research firm ETFGI LLP, said in a telephone interview.
Active managers have largely resisted offering ETF versions of their products because the structure requires revealing almost all holdings every day. Many fear that would allow investors to replicate their strategy without having to pay fees. Active managers also frequently take multiple days to move into or out of a position. If other investors can detect that movement, they might jump ahead of the manager and benefit from resulting price changes, a tactic known as front-running.
BlackRock and other firms have asked the U.S. Securities and Exchange Commission for permission to create actively managed ETFs that don’t disclose holdings daily. Andrew Donohue, then head of the SEC’s division of investment management, said in 2010 he worried the lack of transparency would disrupt the proper pricing of ETFs. The agency hasn’t approved any of the requests.
ETFs disclose holdings daily in order to keep their share price in line with the market value of their holdings. When those values diverge, market makers create or redeem shares in large blocks, moving a fund’s share price back in line with assets. To do that, market makers need to know a fund’s holdings. Transparency is seen as less a threat to fixed-income funds because it’s more difficult to replicate or front-run managers in the over-the-counter bond market.
Fidelity, which manages $1.6 trillion in assets, is known for top-ranked stock pickers such as former Magellan manager Peter Lynch and Will Danoff, manager of the Contrafund, the firm’s largest stock fund. Under Johnson, the firm pioneered the sale of mutual funds directly to individual investors rather than through brokers, and abolished almost all of the firm’s 8 percent sales charges. The firm also introduced Fidelity Puritan fund in 1947, among the first with a goal of investing in stocks to generate income. Fidelity introduced money-market funds that allowed customers to write checks like with bank accounts. Fidelity allows investors to buy ETFs managed by other investment firms on its website.
Rodger Lawson, formerly the president of Fidelity, said in January 2010 the firm was considering actively managed ETFs modeled on its sector funds. The firm’s Select lineup manages $36.9 billion in 60 funds covering industries from banking and pharmaceuticals to communications and air transport, according to Loporchio and the firm’s website.
Rochte, based in Boston, is now president of Fidelity Select Co., the new investment unit. He worked as a vice president for investment services for Fidelity’s institutional brokerage business from 1996 to 2000.
Rochte would be competing against his former employer. State Street, the second-biggest ETF provider, has 40 industry ETFs with $59.6 billion, said Marie McGehee, a spokeswoman. IShares, the largest provider of ETFs worldwide, offers 77 industry-focused ETFs in the U.S. with assets of $30 billion, according to Christine Hudacko, a spokeswoman.
Industry-based products, especially ETFs, have grown in popularity in recent years among institutional investors and financial advisers who like to rotate into and out of industries based on what areas they believe will perform best, Morningstar’s Justice said.
“More and more investors are using sector funds in lieu of single securities,” he said.
Fidelity’s success in gathering assets to the new products will ultimately depend on performance, Justice said.
The firm’s largest industry-focused fund with direct ETF rivals, the $2.3 billion Select Biotechnology Fund (FBIOX:US), has returned an annual average of 20 percent, after fees, in the three years ended July 31. That beat the returns of BlackRock’s iShares Nasdaq Biotech ETF (IBB:US) by more than 0.5 percentage points a year, and State Street’s SPDR S&P Biotech ETF (XBI:US) by 2.6 percentage points a year.
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