The Problem with Star Managers and ETFs

Includes: BLK, ONEQ, WETF
by: IndexUniverse

By Murray Coleman

Is Fidelity finally ready to jump into ETFs in a big way? My sources say maybe … but there could be one troubling hitch.

As we noted last week, the name of Fidelity Investors as a possible suitor of ETF sponsor WisdomTree Investments (WSDT.PK) has been raised. (See story here.)

But even before, speculation has been swirling that the mutual funds giant is concerned enough about the rise in popularity of ETFs to seriously explore taking a bigger step into the marketplace. In 2003, it made a tepid move in that direction by launching the Fidelity Nasdaq Composite Index ETF (NASDAQ:ONEQ).

Within the past week, I’ve heard from reliable industry sources that Fidelity representatives have met with a few key global financial services players to explore potential opportunities in the ETF market.

On Monday, a representative of Fidelity declined to comment for this column. Perhaps more to the point, he also wouldn't confirm or deny whether the company was pursuing a new strategy with ETFs.

Implications Down the Road

It’s not clear yet whether Fidelity is interested in swallowing a smaller yet established player, or if it is considering launching more of its own ETFs. It certainly has plenty of in-house talent and resources to do the job. Those include institutional quantitative fund manager Geode Capital, which Fidelity spun off in 2003. Geode Capital manages more than $50 billion in assets, and is sub-adviser to Fidelity’s line of index-based mutual funds.

But how likely is it that Fidelity, the antithesis of index-minded fund companies like Barclays Global Investors and Vanguard, is interested in entering the ETF arena dealing in just passively managed funds?

It’s true that Fidelity a few years ago slashed expense ratios on its index mutual funds, undercutting Vanguard’s pricing to a point where the fund’s expense ratios are competitive with ETFs. Fidelity is obviously quite aware of the growing pricing pressure that ETFs present to mutual fund managers big and small.

(It might also be worth noting that Fidelity’s active mutual funds are already relatively low cost compared with the cost structures of most other active management shops.)

So why would it be interested in helping drive costs down more? There’s a wild card here that even a huge manager like Fidelity can’t control—the rise of independent fee-based advisers.

Although it has enhanced its distribution network and products aimed at that crowd in recent years, Fidelity still must contend with more cost-conscious money managers. Increasingly, advisers are turning to ETFs as a way to reduce expenses for their clients and gain more control over managing their own portfolios.

Another Float In The Parade?

Whether Fidelity joins the ETF parade is still very much in doubt. But consider that even Pimco’s esteemed bond manager Bill Gross is admitting publicly that mutual funds will increasingly feel the heat of lower-cost structures provided by ETFs as time goes by. That’s after Pimco formally filed to launch actively managed stock and bond ETFs last fall. (See related story here.)

And with rival institutional active manager BlackRock swallowing BGI and its iShares family of ETFs, Fidelity has to be looking over its shoulders at least a bit more these days.

All of this speculation (and that’s all it is at this point) begs an even bigger question. As more mutual fund and institutional active managers start eyeing the ETF market, how will they contend with the continued stance by regulators demanding daily transparency on all exchange-traded products?

We’ve seen some active equity products sneak through the cracks. But those so far have been implementing largely quant-based methodologies. A partnership between Grail Advisors and American Beacon earlier this year resulted in the first stock fund that looks and acts like what we’d expect from a traditional, purely qualitative active mutual fund. (See related story here.)

Grail officials say they’re convinced plenty of fund managers are willing to sacrifice competitive concerns (i.e., the risk that other fund managers will copy or play off what they are doing) in order to advance a greater good. That would be more transparency for you and me.

A (More) Level Playing Field

Grail has certainly assembled an experienced and prestigious group of managers to preside over its initial funds. However, an argument can be made that Grail is hedging its bets. By using a multi-manager approach, isn’t it true that rivals can’t really be so sure exactly what moves are being made—or by which manager—at any given time?

So the question remains—can someone like Fidelity, which uses a largely single-manager approach—really enter the ETF market with a traditional, pure actively run portfolio? It’s a dilemma that Pimco, which also goes with a star manager system, must deal with now that the bond fund maven has made its intentions known to launch both active and index ETFs targeting stocks as well as fixed-income.

Look for more pressure on the Securities and Exchange Commission to ease its transparency requirements for ETFs. And with BlackRock (NYSE:BLK) on the scene, expect more of a push by big active managers to introduce different and unique hybrid processes.

If they can’t sway the SEC, the next best hope of star managers getting a beachhead in ETFs might just come down to their ability to advance various “black-box” methods now being floated using shadow portfolios and a host of other sophisticated strategies.

But would these types of star-managed ETFs really represent progress in delivering to investors more transparency, cheaper costs, and, ultimately better long-term results?

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