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Originally published Saturday, November 9, 2013 at 8:06 PM

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Consumers win as Fidelity sits on ETF costs | Chuck Jaffe

“These companies are embarking on a pretty ugly price war. For investors, this has the potential to be a pretty glorious time,” said industry consultant Geoff Bobroff.


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Fidelity Investments recently proved the line about how an 800-pound gorilla gets to sit “anywhere it wants” when the company announced a new suite of sector-oriented exchange-traded funds, and squatted squarely in the territory of low costs, essentially ensuring that investors are about to enjoy the fruits of a cost-cutting war as the industry’s big apes slug it out.

The headline news was that Fidelity launched 10 new passive-sector exchange-traded funds (ETF), each with a total expense ratio of 0.12 percent, and available commission-free through the company’s brokerage platforms.

While Fidelity touted that the expense level represents roughly an 80 percent discount to the average ETF in the space, the real story is that the Fidelity MSCI Index ETFs launched with costs that are 0.02 points less than Vanguard offerings tracking essentially the same indexes.

“These companies are embarking on a pretty ugly price war,” said industry consultant Geoff Bobroff of East Greenwich, R.I. “For investors, this has the potential to be a pretty glorious time, because once prices have dropped, there’s really no way for the companies to bring them back.”

While Fidelity has been slow to enter the ETF space, its recent announcement changed all that.

“Fidelity is not just seeking entry into the ETF business, but is clearly seeking market share from the get-go in the sector ETF sleeve [of the business],” said Jim Lowell, editor of the Fidelity Investor newsletter.

Industry watchers note that Fidelity has played this game before, and with great success.

Years ago, Fidelity engaged in a price war with Dreyfus in the money-market fund space, each waiving fees to create the highest yield possible, hoping to capture market share even if the business model was showing minimal, if any profits as a result.

Fidelity could engage in that kind of war because its core revenues were not particularly tied to the money-market business.

Fast forward about two decades and Fidelity — in part because it was late to get into the ETF business — is not particularly dependent on the revenues it gets from index funds or ETFs. By comparison, Vanguard’s fortunes are much more tied to those segments.

Thus, Fidelity can come in and cut costs without crushing its profit margins under the weight of the incentives; the company less positioned to survive that fight with its profit margins staying healthy would be Vanguard.

Either way, anyone who buys, trades or considers ETFs benefits from a better cost structure.

No one seems to think that Fidelity’s move puts prices at absolute rock-bottom; there’s still some room for future price cutting.

Exchange-traded funds are mutual funds built to trade moment by moment like stocks; with low costs, tax advantages and ease of trading, ETFs — most of which track a stock or bond index — have racked up roughly $1.6 trillion in assets, or about 10 percent of all assets now held in funds.

Fidelity’s 10 new ETFs are all based on MSCI sector indexes; the firm has hired another ETF giant in BlackRock to act as sub-adviser for the funds; in siding with Fidelity, BlackRock — which also runs the iShares ETFs — helps apply the pressure to Vanguard.

Fidelity and BlackRock had already collaborated on ETF development; earlier this year, they expanded to 65 the number of BlackRock funds available to Fidelity brokerage clients on a commission-free basis; they also have acknowledged working to develop asset-allocation products that, when opened, will carry the Fidelity brand.

Fidelity also plans to create five actively managed bond ETFs, which will be run by its own fixed-income team.

But the real story could be in what happens next. Vanguard recently announced changes to its fund structure.

Vanguard took steps that effectively will allow investors to choose an ETF share class of existing funds, without commissions; this will allow for much greater presence of ETFs in retirement plans, so long as investors there are willing to forego the minute-by-minute trading features.

Because Vanguard holds a patent on the structure that allows a fund company to simply make an ETF as an additional share class of an existing mutual fund, other firms have been working to get around the roadblocks, and the Securities and Exchange Commission seems inclined to move out of the way and leave the big gorillas to slug it out over market forces.

“Innovation in this business is going to keep coming, and we’re definitely looking at what will be next,” said Ram Subramaniam, president of Fidelity Brokerage.

“If you look at the 401(k), investors are starting to save more and are getting more educated and using more tools and better-refined strategies ... and they want the advantages of ETFs available to them, but they are less worried about the intraday trading and liquidity. ... They can get ETFs now if their 401(k) has a self-directed brokerage window, but I think it’s safe to say the entire industry is looking to see what it can do in this space.”

One thing Fidelity’s move may slow down is the emergence of more actively managed ETFs; while plenty of firms are looking into turning traditional funds into ETFs, the low costs and the potential for a price war could bring that activity to a stop until firms are sure they can adopt an active ETF structure and still make money.

Said Bobroff: “You can waive expenses to attract assets, companies have shown that it works. But I don’t believe that if you come to market with a 10 basis-point ETF (expenses of 0.10 percent) that you can ever increase those costs. So fund companies have to be very careful with their long-term strategies right now but, in the meantime, this will get interesting and good for retail investors.”

Chuck Jaffe is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com or at P.O. Box 70, Cohasset, MA 02025-0070.

Copyright 2013, MarketWatch



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