It’s All About the Fees, Fidelity

Fidelity announced its less-than-groundbreaking entry into the booming world of smart beta in April with the launch of a large-cap, value ETF. Now the mutual fund giant is back in the news with another me-too move: It recently cut prices on 27 passive index funds in order to beat or match the already low, low fees that its largest competitor, Vanguard, charges for similar funds.

Jim Lowell, editor of the Fidelity Investor newsletter and website, called the move “hugely significant” — but perhaps that’s a slight exaggeration. The Fidelity Small Cap Index Fund, for example, cut fees from 0.23 percent to 0.19 percent, and the Fidelity 500 Index Fund cut fees — wait for it — from 0.095 percent to 0.09 percent.

Still, it’s easy to see why Fidelity felt like it had to do something. Investors are increasingly demanding lower fees, which is somewhat problematic for a fund family like Fidelity that is widely associated with expensive, actively-managed funds. According to Fidelity, investors yanked close to $19 billion (net) last year from its actively-managed stock funds. At the same time, investors poured a record-breaking $236 billion into Vanguard, a bastion of low-cost, passively-managed funds.

Fidelity no doubt wants to get on the right side of fund flows, but let’s get real — some modest fee cuts to Fidelity’s index funds aren’t likely to transform Fidelity into a go-to passive manager. Fidelity can, however, do something truly significant: It can slash prices on its actively-managed funds.

Investors have every reason to wash their hands of actively-managed funds. Every six months the SPIVA U.S. Scorecard adds another brick to the now towering wall of evidence that the vast majority of active managers fail to keep up with their passive benchmarks. According to the latest year-end 2015 SPIVA scorecard, 83 percent of U.S. stock managers and 80 percent of international stock managers failed to keep up with their benchmarks over the prior ten years. The numbers are similarly discouraging for active bond managers.

The one wrinkle in the SPIVA scorecard is that active managers’ returns are net of their hefty fees, whereas the benchmark returns don’t account for the impact of fees. It’s not clear, in other words, how active managers would fare in an apples-to-apples fee comparison with passive managers.

Fidelity, for one, would compare much more favorably. I looked at the ten-year returns of 111 actively-managed Fidelity funds that fall into one of the SPIVA fund categories. Only 26 percent of those Fidelity funds beat their benchmarks net of fees, which is roughly in line with SPIVA’s results. Also, the funds lost to their benchmarks on average by a margin of negative 0.8 percent annually.

It’s a totally different result, however, without the fee drag. 55 percent of those same funds beat their benchmarks gross of fees, and this time the funds beat their benchmarks on average by a margin of 0.4 percent annually.

So all Fidelity has to do to compare more favorably with passive competitors is to cut its fees on actively-managed funds.

Many investors seem to agree that the problem with actively-managed funds is the fees, not the underlying strategies, because they aren’t abandoning active management altogether. Instead, investors are moving to a cheaper form of active management known as smart beta.

The signs of smart beta’s surging popularity are all around. First, an ever-increasing number of traditional active managers are getting into the smart beta game, from John Hancock to Goldman Sachs to, yes, even Fidelity, to name just a few recent entrants. Second, while investors have scurried to safe havens such as bonds and gold thus far in 2016, smart beta stock funds remain one of the few categories of risk assets that have seen inflows this year. Third, valuations for some smart beta strategies such as quality and low volatility are already high and rising, which speaks to investors’ appetites for those approaches.

Smart beta has always been cheaper than traditional active management, but the cost of smart beta will eventually rival that of passive management. A new Goldman Sachs smart beta ETF, for example, provides a glimpse of the future. It offers four active management styles — value, momentum, quality, and low volatility — for just 0.09 percent annually, which compares favorably with the 0.05 percent expense ratio of the Vanguard S&P 500 ETF.

Fidelity never showed much interest in passive management (Vanguard was long ago crowned king of that realm), but now it’s in danger of ceding its hard won active management throne to smart beta. If Fidelity wants to regain its mojo as a market leader, it should make deep, meaningful cuts to fees on its actively-managed funds.

Source: Bloomberg Gadfly,