How Fidelity is locking arms with BlackRock and appealing to RIAs to fend off a Schwab ETF threat

Brooke’s Note: I’m not sure we’ve seen a battle like this unfold before. Price wars are one thing. But distribution wars are quite another. They involve many more nuances. Fidelity appears to have just made a very shrewd move by aligning itself very closely with the giant of the ETF world — a move that can only make advisors happy. But this battle may still unfold. Less than 15% of all ETFs are on any available on any special ETF platform at all. And with Fidelity and BlackRock so tight, will all the other ETFs flock to Schwab — actually hastening the company’s vision of being a one-stop shop? It’s probably not that simple. This article gets at where Fidelity is coming from and what it has achieved in its iShare deal — and why BlackRock is pleased to be along for the ride.

Fidelity Investments and BlackRock Inc. have both seen this movie before — the one where Schwab creates a category-killing no-fee supermarket of funds, gives it the unabashedly monopolistic name of OneSource and takes a fat middleman fee that pays out for decades.

Schwab showed last month that what it did on the mutual fund side of the business it has every intention of pulling off with exchange traded funds. See: Schwab makes play for ETF-distribution domination but not without risks.

But yesterday the world’s largest broker, Fidelity, and world’s largest asset manager, BlackRock, showed that if Schwab can pull a double in fund distribution, it won’t be because they took its play for the $1.4-trillion ETF market lying down. The Fido-BlackRock duo unveiled a strategy in which not only is some pricing lower but the value delivered higher by minimizing costs to investors resulting from low liquidity — an issue that many RIAs are especially sensitive to.

This deal, it turns out, has roots that extend much deeper underground than anyone originally realized. See: Fidelity and BlackRock are cooking up a de novo ETF company deep in the Rockies.

Counter-punch

For starters, Fidelity and BlackRock announced they’re extending their partnership, which began in 2010, and are more than doubling their iShares from 30 to 65 commission-free options available through Fidelity. Even though Fidelity is late to the ETF game, the Boston-based company’s ammunition to attack the $1.4 trillion ETF marketplace is a counter-punch appealing to the sophistication of RIAs rather than typical retail investors. See: 9 things RIAs need to know about Fidelity’s pricing moves on equities and ETFs.

As with Schwab, these ETFs will be commission-free, but, according to Fidelity, its expense ratio of 34 basis points will even be lower than Schwab’s average of 48 basis points.

But that savings can be dwarfed by diminution of trading spreads in the Fidelity scheme. It uses a lineup of ETFs in iShares that trade in massive volume that creates the liquidity that minimizes the difference between the bid and ask price. These spreads are like Greek to consumers but most RIAs are quite aware of what a big difference they can make in buys and sells.

“Clearly, Fidelity appears to be going after RIAs,” says Paul Weisbruch, president of ETF sales and trading at Street One Financial LLC in Huntingdon Valley, Pa. His firm gets hired by RIAs who are seeking to find the right ETF strategies and execute them at low cost.

“iShares tend to be a favorite of RIAs because of higher average daily volume levels. The Schwab products have less volume, wider spreads and a higher level of difficulty in trading. Those are all facts. Assuming that the RIA or investor cannot utilize a liquidity providing trading desk for specialized order handling, it will tend to be easier to trade the iShares because there’s more volume and tighter spreads. For retail investors, it could just add up to pennies and won’t matter, but for RIAs and money managers moving out of larger positions, 1 to 3 cents is meaningful.”

According to Morningstar’s Feb. 1 data, Fidelity’s lineup with iShares represents 17.9% of the ETF market share, compared with Schwab’s 3.4%.

ETF use on the rise

ETF use among RIAs is growing, according to data released today from Broadridge Financial Solutions, a company that provides outsourcing options for broker-dealers, banks and mutual fund companies. Broadridge’s data shows that RIAs managed $274 billion in ETF assets at the end of 2012, an increase of 26% compared to $217 billion RIAs managed in ETFs at the end of 2011.

Paul Weisbruch: Clearly, Fidelity appears to
be going after RIAs.

Peeling the onion

The iShares S&P 500 Index fund (IVV) and the iShares Barclays 20+ Year Treasury Bond ETF (TLT) alone have average trading daily volume higher than all 100 of Schwab’s commission-free ETFs, observes Mike Durbin, head of the RIA custody unit of Fidelity Institutional Wealth Services.

“We feel that the story about ETF investing goes beyond the simple costs and is like an onion, and there are several layers,” Durbin says. “The trading volume is a huge factor that many people forget about, and I think it’s a significant advantage for Fidelity with this partnership with iShares.

While the ETF’s expense ratio is important, Durbin believes that the company’s trading and daily liquidity are all attributes that RIAs need to consider when deciding where to invest.

“We’re excited about this, because more and more of our advisors are awake to the fact that you can’t just focus on commission or expense ratio, you also have to focus on the size of the order and the daily trading liquidity. We feel very strongly that this offer is better than what Schwab has available,” Durbin says. “Fidelity is a world-class asset manager and we’ve chosen to partner with the biggest and best firm in ETFs. We think this will grow overtime for RIAs and investors alike. There’s a lot of innovation and upside we can do working with the market leader.”

Choosing teams

For its part, Schwab, through spokesman Greg Gable, declined to comment for this article. Schwab certainly made its own headline news last month with the announcement that it would be offering 105 ETF portfolios available with no online trade commissions — still the largest, most diversified and inclusive of these nascent platforms from the big players.

John Hyland, an executive with United States Commodity Funds, says that Schwab’s ETF OneSource has already been a positive experience for his firm.

“The preliminary month-end data from Schwab shows that the flows into ETFs on the OneSource platform as a percentage of all flows into all ETFs at Schwab jumped from the time period just before the launch compared to the balance of February (we are talking about all ETFs, not just USCF’s ETFs). The jump in percentages terms was not trivial, it was actually very large, and appear to be true both for the flows from retail clients as well as flows from RIA directed accounts. Still, we are talking about a few weeks so I would not want to declare victory just yet.”

He adds: “There are obviously differences between the Fidelity platform and Schwab OneSource. Aside from the fact that it is just one provider, the Fidelity offering is much more limited in scope at present. For example, whereas Schwab has 10 different commodity ETFs from two different issuers on the platform (crude oil, nat gas, gasoline, gold, silver, platinum, palladium, silver, two baskets of metals, and a broadly diversified basket of commodities), the Fidelity platform has none. I mean, I know it means more to us than to many others, but commodity ETFs are 10% of the ETF universe. Fidelity does not have any? Not even one physical gold ETF? There are also zero currency ETFs.”

The Fidelity counter-announcement caused waves in the industry by making clear that companies are choosing up sides. In the mutual fund arena, it’s commonplace for mutual funds to be offered up by every clearinghouse possible. See: Why many RIAs should start a mutual fund, considering the limitations of SMAs.

In the ETF arena, companies appear to be, for now, aligning strategically. See: Relentless TD Ameritrade antes up a killer ETF platform.

Schwab is mimicking its own OneSource mutual fund program and dubbing it ETF OneSource. In that effort, the company is teaming up with advisor favorites such as Guggenheim Investments and PowerShares. See: State Street’s semi-secret success in the RIA custody business. It also includes lesser-known brands such as ETF Securities and United States Commodity Funds. Schwab also offers ETFs under its own brand.

Nicholas Gerber, CEO of United States Commodity Funds say he was incentivized to join OneSource by assurances from Schwab that his company would get the deal exclusively — along with the other four providers — for the first year. Schwab’s Greg Gable said this is not true but declined to say what was inaccurate about it.

Tom Lydon: BlackRock was smart by
talking to Fidelity and telling them
that this ETF thing won’t go
away and that 'we should partner
together.’

Steep stairway to success

The continuing partnership of Fidelity, which administered $1.7 trillion in assets at the end of 2012, and BlackRock, whose assets under management stood at $3.792 trillion on Dec. 31— is quite a brilliant one, says Tom Lydon, president of Global Trends
Investments in Irvine, Calif. See: How ETF Trends’ Tom Lydon went from blog writer to hirer of veteran Dow Jones talent.

“BlackRock was smart by talking to Fidelity and telling them that this ETF thing won’t go away and that 'we should partner together.’ This is going to give iShares even more distribution. I think this is the beginning of a pivotal shift,” he says.

“There are many steps to the stairway, but obviously Schwab was looking to squeeze a lot of press out of its OneSource program and now Fidelity and BlackRock are trying to do the same thing. Are these programs individually enough to make an advisor who has a big custody relationship move? Not necessarily. But in the end, the clients have more choices for less money, and that’s positive.”

Clearly, both Fidelity and BlackRock will gain more assets with the combined marketing forces working together, Lydon adds.

Neither BlackRock nor Fidelity officials would offer up specifics of the agreement, but it appears that BlackRock can still offer its product through other custodians. (So Schwab may eventually have BlackRock, too.)

Right now, BlackRock spokeswoman Melissa Garville says, the company is focused on its partnership with Fidelity.

“For BlackRock, we believe this is the most effective distribution play available to us in the U.S. Fidelity is America’s No. 1 direct distributor, reaching more than 10 million customers,” Garville says. “This represents the latest in a series of initiatives aimed at bolstering the iShares value proposition with investors in the U.S. — including the launch of the iShares Core Series, the integration of the BlackRock and iShares retail sales teams and the iShares brand initiative which debuted last fall. The alliance will enhance BlackRock’s ability to deliver the resources and expertise necessary to meet the needs of end-investors.” See: How BlackRock plans to grow iShares using advisors as one key.

Garville adds that Fidelity and BlackRock have had a solid relationship since joining forces in 2010.

“Detailed discussions on the extension of our relationship started in January as our original agreement was coming to an end. Further, this is a unique opportunity for two of the industry’s best to work together for the benefit of Fidelity’s customers. We are focused on this deal,” she says.

More flavors needed

Still, while these commission-free ETFs are attractive, Weisbruch says that to make a real dent in the ETF market, these commission-free products need to offer more types of ETFs. Right now, there are so few available in this arena and there are more than 1,400 available

“The way we look at these commission-free platforms is, until they list more ETFs in terms of percentage-wise, I’m not sure anyone is a game-changer. There is 1,423 and we have 200 or so available commission free. Mostly, the broad-vanilla ones are covered but the more esoteric ones aren’t out there. We’d be excited if there were 500 out there.”