Fidelity targets bruised Pimco, launches actively managed bond ETFs

Fidelity Investments is introducing its first set of bond ETFs Thursday, bringing its active management heft and massive product-distribution capacity to a corner of the investment business currently dominated by Pimco. Although outflows at Pacific Investment Management Co. — estimated by Morningstar Inc. at more than $95 billion over 15 months — have largely sidestepped its ETF lineup, Fidelity believes that the situation provides an opportunity to add to its competitor's woes. (More ETF insight: Why ETF managed portfolios are getting more popular) The leader in actively managed exchange-traded funds, Pimco in September lost 5.5% of the assets in its ETFs — about $742 million, ETF.com estimates — after the abrupt departure of Bill Gross, who left on Sept. 26.. He's now a portfolio manager for Janus Capital Group Inc. Mr. Gross had run one of the most successful ETFs in history, the Pimco Total Return ETF (BOND), an offshoot of its flagship mutual fund, Total Return (PTTAX). (Read more: On Bill Gross' next chapter at Janus) Fidelity, the top U.S. active manager, is launching its first actively managed ETFs, three products positioned as “core” bond holdings: Total Bond ETF (FBND), Limited Term Bond ETF (FLTB) and Corporate Bond ETF (FCOR). The funds, which will invest in a wide range of corporate bond issues, are managed by portfolio managers from Fidelity's mutual fund fixed-income team. “I would say the timing of our launch is fortunate; however, this is part of a really well-thought-out long-term strategy around ETFs,” said Scott E. Couto, president of Fidelity Financial Advisor Solutions, which sells Fidelity funds to advisers, brokers and institutions.

SELLING POINT

As a selling point, his wholesalers are telling advisers that the benchmark 10-year Treasury note is unlikely to be hobbled by significantly higher interest rates unless economic growth in the U.S. accelerates dramatically. That's an argument for discounting the potential for rapidly rising rates and maintaining traditional bond positions such as those in the new funds in the hopes of benefiting from sources of return including “roll-down.” This occurs when investors hold longer-duration bonds and benefit from price increases that would in theory occur if the yield curve is normal, sloping upwards, or particularly if it is steep. In that case, bond yields should decrease as they get closer to maturity. Yields and prices move inversely, so their market price should also increase. Mr. Couto said roll-down is a less-understood component of bond math among his clients. For months, Fidelity has been making an argument that advisers should avoid alternative fixed-income products, a fast-growing classification that includes products such as the Janus Global Unconstrained Bond Fund (JUCAX) now run by Mr. Gross, who also argues rates will rise less than historically would be the case. (More from Bill Gross: He answers advisers' questions about his new fund) Mr. Cuoto argued that nontraditional products have “pretty high” correlation with equity markets, which — if true at an inopportune moment — could erode their ability to provide protection from a stock-market downturn. Unconstrained managers often say they have the flexibility to avoid the negative effects of rising rates on bonds. After years with just one fund, Fidelity launched 10 passive, stock-tracking ETFs a year ago in partnership with sometime-competitor BlackRock Inc., a giant in ETFs and funds that lacks its own retail brokerage platform like Fidelity's, the third-largest by number of affiliated independent advisory firms. In under a year, that tranche of ETFs surpassed $1.4 billion in assets under management, according to Fidelity. Pimco had $13 billion in all its ETFs last month, according to Morningstar Inc. While Pimco built its ETF business, most traditional mutual fund companies — which built empires on the promise of beating benchmarks — sat on the sidelines. (Fidelity executives blanched at the suggestion they're “late” to the ETF market.) But they've echoed the arguments of other companies in explaining their lack of actively managed ETFs. Fidelity, for instance, has told regulators that because it is “an active manager that uses proprietary research and expertise to manage client portfolios … in many circumstances, it may not be appropriate for it to make its portfolios or strategies 'transparent.'” Fidelity asked the Securities and Exchange Commission to allow it to launch actively managed funds that would not disclose their underlying holdings as regularly as is currently required. Fidelity's most recent proposal was first reported by InvestmentNews. The regulator has indicated it may offer an opinion on some “nontransparent” proposals by year-end. In the case of the bond ETFs, Mr. Couto said that after studying the issue, Fidelity managers feel the transparency of its holdings would not hurt performance because bond portfolios are not easily replicated in part because the pricing and availability of bonds can vary widely at different times and trading desks. Most ETFs seek to match, rather than exceed, returns of a benchmark index. Assets in them grew by 115% to nearly $1.7 trillion between 2009 and 2013, according to the Investment Company Institute. Fidelity's new funds won't have many competitors other than Pimco in this space as bond products have proven more challenging to create. Just 19 brands offer taxable bond ETFs; half have less than $1 billion in assets. In a statement, Fidelity said its pricing is “competitive.” In 2013, the average investor in actively managed fixed-income ETFs paid 51 basis points, or 0.51%, in expenses annually, according to Lipper Inc., slightly less than the 54 basis points paid by investors in all actively managed, taxable fixed income products, including mutual funds. Fidelity's new ETFs are priced at 45 basis points. Fidelity's brokerage clients — including more than 3,200 registered investment advisory firms who hold $660 billion in assets in custody at the fund house — can trade them without paying commissions, although there are some fine-print conditions on that offer.