What's Behind Fidelity's Waiver of ETF Commissions?

Fidelity was all over the financial news last week with their announcement of no-commission trades on 25 ETFs from iShares (good through 2013 for the time being), along with a flat $7.95 commission rate on all trades made online.

As Allan Roth pointed out, this is very good news for ETF investors, because it eliminated the main point of differentiation between ETFs and index mutual funds. Prior to Fidelity's announcement, brokerage commissions made it difficult to justify dollar-cost-averaging into an ETF -- the fees on each purchase would likely eliminate any expense ratio advantage the ETFs offered.

But as great as this news is for ETF investors, it also begs the question: What's Fidelity's motivation?

Fidelity remains one of -- if not the most -- widely recognized names in the financial services industry. And their advertising budget and their dominance of the 401(k) industry go a long way toward assuring that they will remain one of the first firms investors think of when they hear "mutual funds."

But, strong brand name or no, the past decade has been a very difficult one for Fidelity's mutual fund operations, and their announcement last week represents an attempt to fend off growing irrelevance.

At the end of 2000, Fidelity dominated the mutual fund industry. They were the largest firm, bar none, with a 13 percent share of long-term assets (stock and bond funds). At second and third on the list, Vanguard and American Funds (with shares of 10 percent and 7 percent, respectively) were well in their rear-view mirror.

Flash forward to the end of 2009, and Fidelity's market share has declined to 9.7 percent, with Vanguard (15 percent) and American Funds (12 percent) now well in front of the former industry leader, and two more competitors -- BlackRock and PIMCO -- closing in fast.

But what truly highlights the plight of Fidelity's mutual fund operations is this particular fact: Over the past five years, while Vanguard has taken in $358 billion of new investor cash, BlackRock has taken in $255 billion, and American Funds have taken in $183 billion, Fidelity's total new cash flow was negative - - ($2.3) billion. Given these figures, it's little wonder that Fidelity decided to focus on increasing the reach of their brokerage operations.

But just how did Fidelity -- which has dominated the mutual fund industry nearly from its inception -- fall so far so fast?

Fund performance, certainly, plays a large role. The fact of the matter is that Fidelity's equity funds have been pretty lousy for the better part of a decade. In 1998, 53 percent of Fidelity's stock funds were rated four or five stars by Morningstar, well above the 32.5 percent you would expect by chance (10 percent of all funds are rated five stars, and 22.5 percent are rated four stars). At the other end of the spectrum, 29 percent of their funds were rated one or two stars, a figure that, again, was superior to the normal distribution.

As of 2009, however, just 25 percent of Fidelity's stock funds garnered a four or five star ranking, 30 percent below the 32.5 percent figure you would expect from luck alone, while a staggering 38 percent of their funds were ranked one or two stars. When nearly four of every ten of your funds is lugging around that sort of long-term record, it's hard to get investors excited about your lineup.

But perhaps just as important as that performance record is the fact that industry trends have been moving away from Fidelity. Each of the other five largest managers has been in the right place at the right time over the past decade. Vanguard and BlackRock have benefited from the growth of cost-conscious investors, who have migrated to the firms' low-cost index funds and ETFs. American Funds remained clean while the mutual fund timing scandals took out a large number of their broker-sold competitors in the early 2000s. And Bill Gross and PIMCO took advantage of the great migration into bond funds over the past two years.

Fidelity, on the other hand, has been neither here nor there. Strong fund performance had been their main point of differentiation. When that evaporated, they were left with nothing to fall back on.

With hindsight, the broad acceptance of ETFs seems to have caught Fidelity flat-footed. They have virtually no presence in the one area of the industry that has been growing by leaps and bounds over the latter half of the decade. As I wrote last year, the sale of iShares represented a prime opportunity for Fidelity to fully address this gaping hole in their fund operations, catapulting them into the leadership position of a burgeoning field.

For whatever reason, Fidelity passed. Instead, they have now entered a relationship with the firm that did purchase iShares, BlackRock, in an effort to participate -- at least tangentially -- in the growing popularity of ETFs.

Fidelity's recent announcement brings to mind their move some five years ago to slash the expense ratios of their index mutual funds. The thinking at the time was that they adopted this approach in the hope that some of those investors who had been lured by those low expenses might migrate over time into Fidelity's pricier -- and more profitable -- actively managed funds.

That didn't work out, as the cash flow data show. Perhaps this most recent move will succeed where the previous one did not. But a strategy of increasing assets under management that's based on enticing cost-conscious investors into more expensive actively managed funds -- with spotty performance records to boot -- would seem to be a rather weak one.

Fidelity is and will remain an important player in the mutual fund industry, but their decades-long dominance seems to have come to an end. The lessons of such a shift? Investors are attracted, more than ever before, to low costs and relative performance predictability. And in such an environment, relying on superior performance in order to build an enduring brand is a recipe for eventual decline. Are you paying attention, T.Rowe Price?