Checking Up On Fidelity's New ETFs

FYI: Copy & Paste 8/2/14: Lewis Braham: Barron's
Regards,
Ted

If ETFs are like the Protestant Reformation to the fund industry, Fidelity is the Catholic Church. The House that Peter Lynch built is famous for its active management. That's why to fund insiders it was as astonishing as Vatican II when the $2 trillion money manager launched 10 sector index ETFs of its own last October. Prior to that it had opened only one other ETF, Fidelity Nasdaq Composite Index (ticker: ONEQ), which it let languish for more than a decade.

No one can dispute the new ETFs have been a success. In less than a year, they've gathered $1.2 billion in assets. That's one of the most successful launches since Pimco opened an ETF version of Bill Gross's Pimco Total Return fund (BOND) in 2012, says Dave Nadig, chief investment officer of ETF.com. Yet the ETF evangelist argues that Fidelity did this out of desperation. "Fidelity is trying to stem the tide of outflows," Nadig says. "Over the last five years, there's been nearly $750 billion of inflows into ETFs and net outflows from mutual funds. To not do something like this is to cede the field to ETFs."

The truth is more nuanced. Fidelity's foray into the ETF world wasn't capricious; its index-based sector ETFs are an outgrowth of the actively managed sector funds it's been running for more than 30 years. Moreover, despite the generally bleak outlook for mutual funds, Fidelity's 39 "Select" sector funds experienced $7.1 billion in inflows in the last five years, according to Morningstar, and the firm has seen overall inflows in that period -- there's no tide of outflows. And given the challenges of active management, it's impressive that 22 of those 39 funds have beaten more than 70% of their peers over the past decade.

Anthony Rochte, who oversees Fidelity's sector-fund division, sees the new ETFs as more of a complement to the mutual funds, meant for a different kind of investor, rather than a substitute for the shop's existing products. "We realized that ETFs are critical to investors who might want to be more tactical," he says. "Mutual funds may not be the perfect fit for a financial advisor or individual investor who wants to trade intraday." Of the $600 billion invested in sector-based portfolios industrywide, more than 40% is invested in such aggressive ETF trading strategies, Rochte says.

CERTAINLY, THE NEW ETFS have many features that will appeal to sector rotators -- especially those who are already Fidelity customers. If you buy shares at Fidelity, there are no transaction fees, although like other brokers who offer such free trades, Fidelity will impose a $7.95 short-term penalty if you hold your shares less than 30 days. Longer-term investors will also appreciate the ETFs' 0.12% expense ratios, the lowest for their sectors. The ETFs also represent their sectors better than competitors by holding more small companies. Fidelity MSCI Health Care Index ETF (FHLC), for instance, has 311 holdings, including many small, rapidly growing biotech companies, compared with the 55, mostly blue-chip stocks in the better-known Health Care Select Sector SPDR (XLV).

That said, volumes in the 10 ETFs have only ranged between 36,000 and 93,000 shares a day over the past three months -- good enough for individual investors but not large institutions. "Those volumes are nowhere near enough for a hedge fund to make major allocations," says Nadig. "But that will come with time." He thinks the ETFs will be successful because Fidelity has a "captive audience" at its brokerage. The firm has more than 15 million retail brokerage accounts and 10,000 financial advisors trading on its platform.

FOR LARGE INVESTORS there is also a workaround to buying shares in bulk. David Haviland, who runs $1.1 billion in ETF strategies at Beaumont Capital Management, bought $162 million of Fidelity ETFs in one day earlier this year when trading volumes were much lower than now. Instead of buying the ETF shares via the exchange, his traders contacted market-maker Knight Capital Group, which creates baskets of stocks underlying the ETFs. If you're willing to buy enough shares -- 40,000 in Fidelity's case -- KCG or another market-maker, like Goldman Sachs, will essentially purchase the underlying stocks and create a new batch of ETFs. Dealing directly with a market-maker like this ensures big purchases won't affect the share price on the open market.

Because Haviland employs an aggressive, momentum-based strategy, Fidelity's actively managed mutual funds never held any interest for him. He needs to exit on a dime when an ETF loses momentum to protect clients' capital. So in his case there really is no question of Fidelity ETFs appealing to a different kind of customer, one that is cannibalizing Fidelity's core business.

Other experts believe that whether you substitute Select funds for ETFs depends on which sector you're invested in. Jim Lowell, editor of the Fidelity Sector Investor newsletter, thinks investors might be better off in Fidelity's energy ETF than its active funds because the sector is so volatile and driven by rapidly shifting commodity prices. "You want to be nimble and quick with an energy ETF because you'll more likely be trading out of your position quickly," he says. "The benefits of an active manager aren't there in that space from my perspective."

Still, Lowell favors Fidelity's Select funds overall. "It will be very difficult for any sector ETF that's using a passive index to outperform Fidelity's active managed sector funds over any meaningful investment timeline," he says. While the academic research suggests indexing wins in general, choosing between active funds and passive ETFs at Fidelity remains a matter of belief.