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Tuesday, December 13, 2011

401k is Not Why Fidelity Likes ETFs

News summary by MFWire's editors

After roughly a decade of letting its ETF efforts lie fallow, why is Fidelity exploring the space now? Trade pub Ignites states that Fidelity's recent filings are "likely an attempt to retain asset management and other fees in two of its most profitable distribution channels, brokerage and retirement." Does that make sense?

In one case "no", and the other "yes".

The Boston Behemoth's recent move to lay the groundwork for an ETF play is all about its brokerage business and not protecting its 401k franchise. The driving reason is that the world is becoming starkly divided between those who buy ETFs and those who buy mutual funds.

The 401(k) retirement market case made in the Ignites report is that coming fee disclosure in the retirement plan market is pushing asset managers and retirement plan providers to offer lower-cost ETFs so that they do not lose out to competitors.

"Fidelity already offers a range of index funds at a low cost for very large retirement clients, but doing so with ETFs will allow the firm to tap into the fast-growing movement," claims Ignites citing analysis from Tom Lydon, editor of ETF Trends and president of RIA firm Global Trends Investments.

Ignites adds that Fidelity's filings are a step made in defense of its $726 billion in AUM retirement business that accounts for half of its entire asset base.

The article points to Charles Schwab's plans for an all-index ETF 401(k) recordkeeping system and TD Ameritrade's efforts in that area to bolster its argument.

Yet, the 401(k) space has seen little demand from plan sponsors or plan participants for ETF products to date. Schwab's product is still vaporware and TD Ameritrade has been trying to find a way to unlock the door to ETFs in 401(k) plans for half a decade with little success.

The article fails to mention efforts by BlackRock's iShares unit to crack the ETF business. That firm touted a partnership with BenefitStreet, an effort that has virtually disappeared from the market.

Bottom line: There is little reason for Fidelity to be creating 401(k) business plans around ETFs.

The area where ETFs does make sense is Fidelity's brokerage business. Custodians operating mutual fund markets are finding that some advisors and investors are becoming ETF loyalists, making the investment vehicle a first cut in their screening process.

For custodians the growing number of clients putting ETFs vehicles ahead of mutual fund vehicles has profound implications.

Where mutual funds pay platform fees of up to 40 basis points annually as well as listing fees, ETFs are accounted for as stocks and provide no ongoing revenue to the custodians. That means that every time a mutual fund shareholder converts to an ETF the custodian sees its ongoing revenue stream cut.

Custodians worried by this trend -- including at least one of the wirehouses -- have quietly approached the major ETF players over the past year and asked for ongoing revenue sharing, the MFWire has learned from mutual fund executives. So far, the ETF players have rebuffed those attempts.

Fidelity's temporary solution was to cut a special deal with BlackRock's iShares in which iShares paid Fidelity for FundsNet shelf space and gained commission-free status for some of its ETFs. That deal runs through at least 2013, and according to rival ETF sponsors, cost BlackRock a seven-figure fee.

The alternate answer, and one that is being pursued most aggressively by Charles Schwab, is to join them if you can't beat them. In 2009, Schwab executives looked at the numbers and decided that if OneSource was going to lose assets to ETFs, those ETFs may as well be Schwab's own. The theory being: "better to collect the asset management fee, no matter how small, than no fee at all."

So far it is not clear how well Schwab's strategy is working out. Its proprietary ETFs account for $4.8 billion in assets compared to $109 billion in ETF assets on its custody platform, reports Ignites.

It is a safe bet that those running FundsNet are thinking along similar lines.

Interestingly, Fidelity's relief filing outlines products that would use a master-feeder fund structure to allow the ETFs to invest in the same portfolios used by Fidelity mutual funds.

If its ETFs capture client assets flowing out of mutual funds in FundsNet, Fidelity would be able to keep those assets in its own hands. 

Edited by: Sean Hanna, Editor in Chief

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