Fidelity Investments runs businesses in fields as diverse as retail banking and hydroponic tomatoes, but when it came to launching exchange traded funds, it saw fit to ally with one of its fiercest competitors.
Other late entrants into the US ETF market are likely to forge similarly uneasy alliances, given that the three biggest providers – BlackRock’s iShares, State Street Global Advisors and Vanguard Investments – control more than 80 per cent of assets and boast first-mover advantage in tracking the major indices, allowing them to pare fees mercilessly.
“The Fidelitys of the world understand they cannot compete with iShares, State Street and Vanguard,” says Richard Keary, principal of the consulting firm Global ETF Advisors. “They know they have to find some other formula to get in.”
Fidelity’s formula entails leveraging its distribution might in exchange for product support from industry leader BlackRock. Since 2010, its brokerage business has sold iShares ETFs commission-free under an exclusive arrangement.
Last year, Fidelity expanded on the partnership by launching 10 sector equity ETFs subadvised by BlackRock – effectively marking Fidelity’s long-awaited arrival in the ETF market. Fidelity maintains the agreements merely filled a gap in its product menu – passive sector investment – that it did not want to fill itself, freeing up resources for active fund development.
“Partnering with BlackRock from the subadviser standpoint made a lot of sense for the customer in that iShares obviously has been managing ETFs for a number of years on the passive front,” says Anthony Rochte, president of Fidelity’s SelectCo sector investment unit. “And it really allowed us to focus on what we do well, which is active management, and really get in the market and quickly deliver what our customers are looking for.”
Fidelity is collaborating with BlackRock on the development of managed portfolios built on ETFs, which are expected to launch soon. The company has also filed to launch active ETFs investing in mortgage securities and corporate bonds. Mr Rochte declined to comment on the possibility that Fidelity might launch active ETFs in partnership with BlackRock or other ETF providers.
Mr Keary sees Fidelity’s BlackRock tie-up as a shrewd trade-off. “They are leveraging their strength in distribution to allow some of these ETFs on their platform and at the same time creating new ETFs based on what their clients are asking for,” he says. But it is a trade-off. Typically, subadvisers in such arrangements will claim a share of the fund fees, coupled with a cash payment for services rendered, says Mr Keary.
MFS Investment Management, another US mutual fund powerhouse that had shunned ETFs, entered the market this year as a subadviser to a suite of ETFs from SSgA, the second-biggest ETF provider. SSgA is handling marketing, distribution and branding.
MFS views the SSgA rollouts more as new mandates for its longstanding subadvising operation that happen to involve ETFs, rather than heralding a full-fledged entry into the ETF market. “MFS does not have plans to get into the ETF business directly at this time,” says spokesman James Aber. “MFS believes in active management and saw an opportunity to leverage an existing capability to take advantage of a developing trend in actively managed ETFs.”
SSgA has recruited subadvisers before – last year, it launched a senior loan ETF subadvised by Blackstone Group’s GSO/Blackstone Debt Funds Management – and probably will again.
“It’s not a new model for us,” says Jim Ross, global head of SSgA’s SPDR ETF business. “We look at it as a platform to bringing best-of-breed in the marketplace, and if we can deliver that through a partnership structure, we will look toward that model.”
MFS is of course perfectly capable of marketing its own products, just as Fidelity knows how to manufacture and manage index funds. Lack of ETF industry scale, however, is not their only problem. They both also need to learn about the mechanics of running ETFs, which differ from mutual funds in the creation-redemption process, says Kris Monaco, head of ISE ETF Ventures, a division of the International Securities Exchange.
“Even larger firms need assistance in entering the market,” says Mr Monaco, whose business unit provides capital to ETF roll-outs in return for a share of revenue.
“When you look at the examples of MFS and Fidelity, the overarching issue for larger firms is that they’re very capable of creating and having ETFs listed, but they’re not wired the right way from an infrastructure point of view to make sure they get the broadest distribution possible [and also] get the funds efficiently operated on a day-to-day basis; that’s infrastructure that has to be built.”