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ETFs Eating Fidelity’s Lunch

“ETFs are beginning to eat everyone’s lunch in this industry.”

The above quote refers to the mutual fund industry and comes from none other than Jim Lowell, the editor of the Fidelity Investor newsletter.  A recent Bloomberg article highlighted a number of reasons for deteriorating asset levels at Fidelity, the largest mutual fund company in the world, and Lowell points directly to Fidelity’s lack of penetration into the growing ETF space as a primary cause.

Fidelity has watched its assets fall 4.9% over the past decade while the company’s total market share, including ETFs, decreased from 14.4% to 9.9%.  Poor fund performance (only 32% of the company’s funds beat peer funds in 2008) and the lack of a flagship fund to draw in new investors (no Fidelity fund ranks in the top ten in terms of assets) were clearly factors, but it’s apparent that the company’s failure to capitalize on the massive asset flows into ETFs was also a key culprit.

Comparatively, companies like Barclays Plc, State Street Corp, and Vanguard, the top three in exchange-traded fund assets, have continued to gain overall market share.  Consider Vanguard, the second largest mutual fund company, which saw their assets climb 91% over the same time period.  This comes as no surprise considering Vanguard’s concerted effort to become a major ETF player.  According to the Bloomberg article, Fidelity has only $65 million in ETF assets compared to Vanguard’s $40 billion (where a meaningful chunk of the company’s overall asset growth has originated).

In his latest newsletter, Lowell strongly recommended that Fidelity bid for iShares, the Barclay’s ETF business unit which they recently agreed to sell to CVC Capital Partners Ltd for $4.4 billion, in an attempt to stop the bleeding of assets and make an important strategic play in an industry increasingly gravitating towards ETFs.  This would have been a prime opportunity for Fidelity to immediately catapult to the top of the ETF industry and leverage their significant distribution and marketing muscle in a blossoming asset market.  Instead, Fidelity faces an uphill climb as they attempt to develop a viable ETF strategy to avoid getting their lunch eaten by the competition.  They had better move quickly.

Separating the Cart (instrument) from the Horse (strategy): The Real Beauty of ETFs

The educational starting point for all investors new to ETFs, be they novice or experienced professional, ought to be Investment Cart & Horse 101.

 ETFs enable investors to clearly and objectively distinguish, both in investment thinking and in investment practice, between the proverbial “cart” and “horse“, i.e., the investment instrument and investment strategy.

The gross mismatch between an active fund manager’s stated investment objective(s), and the broad (prospectus-imparted) license to roam widely and at will across much of the investment landscape, renders separation of investment instrument from investment strategy absolutely and utterly impossible to discern within the actively-managed mutual fund.

 For investors and advisors, unfortunately, any attempt to use actively-managed mutual funds to construct a disciplined and coherent strategy – one which demands control and predictability regarding the composition of portfolio holdings – is inescapably and entirely rendered an exercise in futility. “Asset allocation” strategies, at best, devolve to an extremely crude approximation game as individual fund managers exercise broad discretion in modifying, at times quite dramatically, security and asset class composition within their funds. Gone, usurped by active mutual fund managers, is investor or advisor control over the composition and modification of their strategy.

 In contrast, index-based ETF instruments provide a systematic, rules-based recipe for gaining exposure to a broad market or segment of a market. And while mutual fund reported holdings data ranges from three to five months stale, daily reporting of ETF holdings enables the investor or advisor to see precisely how index rules are reflected in a related ETF’s holdings. For the investor or advisor familiar with the index and the ETF, there are no surprises regarding the composition of an ETF. The manner of asset class coverage and security selection are “programmed” into the index and corresponding ETF.

Utilization of index-based ETFs enables the investor and advisor to shed active-manager decision-making risks – a step that is supported by a mountain of academic research and decades of market experience. With index-based ETFs, investor and advisor attention can be focused where it should be: entirely on strategy, understanding that the instruments will deliver intended exposures predictably and reliably. Actively-managed mutual funds rob investors of this capability by undermining the strategy, through manager drift, and weakening investor confidence and resolve to stick with a game plan. Active fund mangers, after all, have no definitive requirement or proclivity to do so themselves.

 In using ETFs, investors and advisors are better equipped to construct and deploy strategies as well as to consider the performance of instruments and strategies independently, largely as a result of their ability to “separate the cart from the horse.” These risk management and control perspectives can never be shared or enjoyed by investors and advisors using actively-managed mutual funds.

Missing the Target

Over the past several years, target-date (or life-cycle) mutual funds have gained popularity as fund companies tout them as an easy way for investors to obtain an appropriate asset mix in their portfolio for a particular age or investment timeframe. 

Theoretically, these funds are designed to allow an investor to select a date that approximately corresponds to their retirement – say 2020 or 2030, and the fund manager will attempt to provide an allocation of stocks, bonds, and cash that becomes more conservative the closer the individual gets to retirement. 

The idea is that the investor can rest comfortably knowing that their investments are properly aligned with their risk tolerance and time horizon. 

However, as an article in Fortune magazine recently pointed out, investors hoping that target-date funds would be a simple way to ensure they were properly managing risk have been shocked by the overly-aggressive nature of these funds.

The article points out that, “According to Israelsen, the average 2010 fund marketed to investors who were aiming to retire next year – was more than 45% invested in stocks in December.  As of March 2008, the mammoth Fidelity Freedom 2010 Fund (FFFCX) housed 50% of its assets in equities, and AllianceBernstein’s 2010 portfolio (LTDAX) was 57% in stocks in February of last year.  The funds lost 25% and 33%, respectively, last year, barely beating the S&P 500.” 

Investors hoping to retire next year surely were not expecting a portfolio allocation that could expose them to 25% or 33% losses.

Industry professionals attribute the miserable performance of these funds to poor execution by fund managers, who in an attempt to chase extra returns that could help market the funds, added unnecessary risk to their portfolios by overexposing to equities.  The performance has been so alarmingly bad that Wisconsin Senator Herb Kohl has asked the SEC and Department of Labor to investigate target-date funds, particularly since many employers offer these funds in 401(k) plans and brokerages aggressively market these funds to investors for individual retirement accounts.

The bottom line is that investors should be wary when considering these funds for their retirement accounts.  In addition to the performance and asset allocation issues described above, expense ratios on these funds can be heavy and funds can include loads or commissions.  Furthermore, the asset mix in these funds is generally limited to stocks and bonds, excluding other important asset classes such as commodities and real estate that can help balance out a portfolio.

SmartMoney: ETFs “pushing mutual funds out of the picture”

There is a great article posted today at smartmoney.com about the gains ETFs are making against mutual funds.  The article describes the rapid growth of ETFs, the fact that some fund companies such as Vanguard are issuing their own ETFs in order to survive, and the benefits to an investor of owning ETFs instead of mutual funds – especially for the bond portion of a portfolio.

The article says there might be a place for actively managed funds in a portfolio (though most people know by now that most actively managed funds underperform their benchmarks over time) but it concludes that “trying to make a case for a mutual fund can be difficult.”

Mutual Fund Company Magic

When a broker tries to sell you a mutual fund, or your advisor touts the performance of a fund he or she wants to put your money into, it is modus operandi to show how wonderful the fund has performed against its benchmark, or relative to its peers.  

Before you jump into the fund, consider the impact of survivorship bias on those published performance numbers.  As the PSY-FI blog explains, survivorship bias is the result of the all-too-often habit of mutual fund companies to merge the assets of underperforming funds into the successful ones. 

Your fund might have a terrible year – perhaps miss its benchmark by 50% or more – but if you blink you just might miss that your fund was closed and your assets have moved into a succesful fund with a great track record….voila, in an instant your fund is gone and your investment is in a fund that has the best 10 year track record of any fund in its category!!!  Your bad investment has magically disappeared. Congratulations!

PSY-FI explains a number of other creative ways fund companies improve perceived returns, including ‘easy history’ bias or ‘easy data’ bias, but the main lesson for investors is simply caveat emptor!