PDF How Fidelity is Positioning Its Index Fund Offerings

How Fidelity is Positioning Its Index Fund Offerings

July 12, 2016 by Robert Huebscher

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Two recent announcements from Fidelity Investments, well-known for its actively managed mutual funds, show that it intends to strengthen its competitive positioning and grow its market share in the index fund business. On June 14, it announced that it strengthened its fund lineup. On June 28, it announced that it lowered expenses on 27 of its mutual funds and ETFs.

I spoke with Colby Penzone, the senior vice president for Fidelity's Investment Products Group, on July 1 about those announcements.

Can you provide some background on your responsibilities and the product suite that you manage?

I lead a group of product managers and we are responsible for the product strategy, development and management of the equity and high-yield products that we distribute at Fidelity. That includes both our active retail and advisor fund lineups, index products, the sector lineup of index ETFs that we have and our institutional strategies, which include co-mingled pools, separate accounts and other offerings.

I want to ask about the two recent announcements from Fidelity. The first was the introduction of three new index funds along with the re-branding of the Spartan funds to the Fidelity name. What was your motivation behind that move?

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As I'm sure you are aware, we've been in the index business for about 25 years. Over that period of time, we have continuously expanded the lineup and sought to provide as compelling a low-cost offering as we can to our clients. This is an extension of us wanting to continue to deliver what we believe is great choice and value in our index lineup across all the distribution channels that we serve including to advisors.

The second announcement was the reduction of expenses on 27 of your equity and bond index funds. What was behind that move?

It's consistent with what I just said. We are constantly scanning the marketplace. We are engaging with our customers, including advisors, to understand their needs, their preferences and their views. We wanted to make sure that we continue to be very, very cost competitive ? if not the lowest provider. We view price as one part of the value proposition that we are providing our clients. Across the different distribution channels we provide a wide array of services and products, whether that is to our retail clients or to advisors or to plan sponsors in our 401(k) business.

In the press release for the second announcement you were quoted as saying "while cost matters, investors should also consider the overall experience and value a financial services firm can deliver when deciding where to invest." What does that translate to?

There are two segments to that answer. There are certainly the advisors to whom we provide platform or custody services, and there is a broad set of capabilities that we bring to bear in those relationships, from technology and capital markets services to practice management and investment insights. For our off-platform advisors, to whom we are now making these index funds available, provided they meet the prospectus minimum, we are providing them not just index funds but a broad array of active products that we believe strongly in, and we think are great for their customers' portfolios. When you combine one of the most comprehensive and competitive investment product lines in the industry with our commitment to delivering world-class service, technology platforms, etcetera, we feel strongly that we offer the best customer experience and value in the industry.

Were either of those changes motivated by the new DOL fiduciary rule?

It wasn't in response to any regulatory change. It's a long-term strategy and we are not making any quick products shifts as a result of any sort of regulatory change.

It seems that you are targeting Vanguard by having lower fees and lower account minimums for equivalent funds. Has the Index fund business become a commodity where firms compete purely on the basis of price?

I'd first say that for us this is about our customers that we serve; it's not about any one competitor. There are benefits of scale in the Index-fund business, and certainly in that space expenses are an important factor. But as I mentioned before, we don't think of it as the only consideration for investors. While cost does matter to investors, whether it is an index or active fund, they should consider the overall experience and value that they are getting.

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Do you fear that competitors ? Vanguard specifically ? will respond by lowering their prices?

We are really focused on our shareholders and our clients. We want to continue to provide them with choice and with value. We think this announcement is good news for Index-fund investors and should give them the confidence that we are going to provide them with low-cost Index fund products in the years ahead. I can't speculate on what competitors may or may not do.

Does Vanguard's structure of being investor-owned give it an advantage as an asset manager because it doesn't have to answer to two constituencies ? its shareholders and its investors? This is the challenge that John Bogle says derives from the fact that "a man cannot serve two masters."

I can't speak to our competitor's organizational structure. Fidelity is a great company with a 70-year history of putting our clients first and striving to deliver the best customer experience that we can. Our private company structure has a lot of advantages, including allowing us to take a long-term perspective when making investments in the business on behalf of our customers. It's that we believe in the value of our offerings, including low costs, which are unmatched in the industry.

Index investing and passive funds have benefited greatly over the last several years in terms of net investor flows. What do you believe has been the reason for this and do you expect that trend to continue?

I can't make predictions. That being said, we believe that both passive and active can play a role in a customer's portfolio and that is one of the reasons why we have been in this index business for 25 years. Of course, we've been in the active business for 70. Fidelity is a strong believer in the powers of active management and the long-term value that it provides investors, but we also want to make sure that we are bringing choice and value to those investors who want to invest in index products.

One of the explanations for the flow of funds to passive investments over the last four or five years has been the fact that investors did very well just being in an Index fund. We went through a period where, on a risk-adjusted Sharpe-ratio basis, the S&P 500 had its best threeyear period ever. It's been hard for active managers to tell a compelling story. Does that resonate at all with your thinking in terms of understanding why passive funds have done so well?

With regard to your point about active managers and relative performance, it can be misleading to use industry averages. We strongly believe in active management, and can prove it works. According to Fidelity research released earlier this year, by using two simple, objective filters ? mutual funds with lower fees from the five largest fund families by assets ? the average actively managed U.S. large-cap equity fund outperformed its benchmark by 0.18% per year from 1992 through 2015, while the average subset of index funds trailed its benchmark by 0.04%. While 0.18% per year of outperformance may not seem like a lot, this may translate to more money to spend, or a longer and more secure retirement. As a hypothetical illustration, suppose a retirement investor saves $5,000 per year in two different accounts, one with 0.18% of annual excess return and one with -0.04% of annual excess return (assuming returns are net of fees and a constant "benchmark" return of 7%). At the end of 40

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years, the balance for the account with 0.18% of excess return would be more than $64,000 higher than the other account, essentially earning an additional 6.0% of cumulative return.[i] Here at Fidelity, we believe that both index and active can play a role in a customer's portfolio. We will continue to provide our customers with great value across both of those styles. That doesn't at all change the fact that we are strong believers in the power of active management and the long-term value that it brings to our investors. [i] Impact of 22 basis points: To illustrate the potential impact of 22 basis points, we assumed two hypothetical portfolios, one earning 18 basis points of annual excess return, one earning ?4 basis points (assuming returns are net of fees), both in relation to a hypothetical benchmark earning 7% constant annual returns. Returns were credited annually at the end of each year, and investor contributions of $5,000 were added at the beginning of each year. Taxes were not considered. After 40 years, the outperforming portfolio account balance would be $1,120,752, while the underperforming portfolio account balance would be $1,056,704, for a difference of $64,048. This example is for illustrative purposes only; it does not represent actual or future performance of any investment, nor is it likely to be duplicated by any specific investment.

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