usinessman analyzing investment charts with laptop
nonwarit/123RF

Boston-based asset-management giant Fidelity Investments Inc.’s recent introduction of zero-fee index mutual funds may accelerate the shift toward passive products, intensifying the pressure on traditional active mutual fund managers, says a new report from Fitch Ratings Inc.

Fidelity’s recent launch of two index equity mutual funds that don’t charge management fees or impose minimum investment requirements, coupled with an average 35% cut in the fees on its existing index funds, highlights the revenue pressures facing traditional investment managers, the credit-rating agency’s report states.

“A broader roll out of zero-fee funds, or further reduction of current fee structures, would exacerbate the long-term earnings pressures facing traditional investment managers,” Fitch’s report states. “This would be particularly challenging for less diversified firms lacking scale and could spur additional mergers and acquisitions.”

Indeed, Fitch’s report states that only a handful of firms are capable of competing on this basis. “Offering zero-fee rates requires [mutual fund firms] to have scale and/or more diversified business models with revenue streams other than base management fees such as securities lending or wealth management, which are only realistically achievable for a subset of larger, lower-cost players including Fidelity, Schwab, BlackRock and Vanguard,” the report states.

Fidelity’s move is clearly designed to grow, or at least defend, its assets under management, the report says, noting that this could enable the firm to capture greater market share in the passive investment sector. And, it says that Fidelity appears particularly well suited to this sort of competitive salvo.

“Fidelity’s diversified business model, including wealth management and brokerage activities, may help reduce the financial impact of forgone management fee revenue. The fact that Fidelity is privately held may also allow it to take a longer-term strategic view versus publicly traded managers that may face greater shareholder pressure for near-term results,” it says.

Currently, Fitch has a stable rating outlook for the investment management sector. “However, should fee and flow pressure accelerate such that it results in EBITDA compression and consequent decline in profitability margins and/or an increase in cash flow leverage ratios, outlooks and/or individual issuer ratings,” it says. “Although not viewed as an imminent threat, to the extent Fitch considers passive allocation sufficiently material and permanent, negative rating/outlook changes could result in advance of the trend being manifested in financial metrics.”

While the advent of zero-fee funds may exacerbate the shift from active to passive funds, Fitch says that it believes that, “long-term investor appetite for actively managed funds will depend much more so on managers’ ability to outperform passive indices at various points in the cycle.”