Fidelity Is Thriving. Here’s What It Needs to Keep Thriving.
Abigail Johnson wants to dispel a rumor on Wall Street that Fidelity would consider a merger with Goldman Sachs . “Absolutely not,” says Johnson, chairwoman and CEO of FMR, Fidelity’s parent company. Other fund companies may be joining forces—Invesco and OppenheimerFunds are negotiating a $5 billion merger. But Johnson says Fidelity is doing fine on its own. “I don’t get complaints from our shareholders about the way things are going.”
Johnson, of course, is one of FMR’s largest shareholders. She’s worth an estimated $17.5 billion, according to Forbes, through her family’s 49% ownership of the firm. She hasn’t worked anywhere else since graduating from Harvard Business School in 1988, rising from equity analyst to the head of asset management and president of various divisions.
Things are indeed going pretty well, based on the numbers. FMR’s revenue hit a record $18.2 billion in 2017, up nearly 14% from the prior year. Assets under management, or AUM, hit $2.5 trillion, up 15%. Assets under administration—which include money in non-Fidelity funds that are in Fidelity brokerage accounts, 401(k) plans, and the like—rose 19%, to $6.8 trillion. That’s more in total assets than any other U.S. asset manager, including BlackRock (ticker: BLK), at $6.3 trillion; Vanguard, at $5.1 trillion; or Charles Schwab (SCHW), at $3.6 trillion. Operating income jumped 54%, to $5.3 billion.
Dig deeper, though, and you’ll see fissures in Fidelity’s story. The firm doesn’t look nearly as profitable as its big publicly traded peers. Its 29% operating margin (operating income is revenue minus expenses such as wages and other costs of doing business) lags far behind the profit margins for BlackRock, Schwab, and T. Rowe Price Group (TROW), all of which exceeded 40% in 2017. Fidelity decided years ago that it would avoid low-margin products like exchange-traded funds and “robo” advisory services—missing out on what could have been big businesses. It has since launched products in both areas.
The firm is dipping into digital currencies like Bitcoin, but it’s hardly a pioneer. Fidelity’s growth, moreover, has been fueled by an investment climate that has lifted all ships: The U.S. bull market, going strong for nine years, has boosted trading volume and assets under management. Robust demand for fixed-income is bolstering the bond side of the business.
So what’s next for Fidelity? How will the firm deal with a new wave of cost pressures, changing investor behavior, and technologies that are rupturing longstanding revenue models?
Barron’s sat down with Johnson at Fidelity’s Boston headquarters to get her perspective. She runs one of the largest financial services firms in America, with 45,000 workers. But Johnson is famously press-shy, and rarely speaks to the media—and even more rarely on the record. (This reporter worked as a writer on Fidelity’s website from 2012 to 2014.)
Johnson, 56, has long allowed other executives to speak for the company, though she recently talked to a Chinese-language publication about Fidelity’s international business and gave an interview to the New York Times in May, addressing recent allegations of sexual misconduct in Fidelity’s asset-management division. Her response was to establish a sexual-harassment committee, institute diversity training, and set up an office on the asset-management floor, sending a message that harassment in the workplace wouldn’t be tolerated.
She starts the Barron’s interview by addressing one of Fidelity’s biggest challenges: overcoming fear of failure. “Being part of an organization with a pretty decent history of success, people tend to think the next thing has to be more perfect than the last,” she says. “They spend too much time and effort trying to make it perfect when it would be better to get it in the market.”
While Fidelity may never win a prize for most nimble or innovative, that may not be necessary. It has built such a diversified business that it may be the closest thing to Amazon.com (AMZN) in the financial industry. Few other companies sell so many products backed by the kind of scale and technology that Fidelity brings to the table. The firm combines retail brokerage, asset management, institutional services like custody and clearing, and a huge workplace division that administers 401(k) plans and other employee benefits.
Brokerage and money management are now just spokes on an expanding wheel. One executive even bemoans the fact that people still refer to the firm as a fund company, noting that its growth is in other areas. Fidelity has become the largest record keeper of 401(k) and other employer-sponsored retirement accounts, with more than 29 million accounts. It sells payroll services to small and midsize companies. It’s working its way into the burgeoning world of health savings accounts and corporate health benefits. The firm administers 889,000 HSAs, up 31% over the past year, covering $3.4 billion in assets (up 44%). It has also launched a service, Fidelity Health Marketplace, pitched as a “one-stop solution for all your employees’ health and financial needs.”
“They have extraordinary scale, and a lot of different ways to bring income into the firm,” says Jim Lowell, a longtime observer of the company and editor of Fidelity Investor, an independent newsletter. “They might not be the biggest in every area, but their scale allows them to increase margins over competitors, and they pick up a little piece of the action on everything.”
The Amazon analogy may sound far-fetched—Fidelity isn’t nearly as dominant, disruptive, or technologically astute. But Johnson loves the comparison. “Many of our leaders have tried to take lessons from Jeff Bezos’ thinking that it’s always ‘day one,’ ” she says. “We talk to the organization about selectively forgetting the past. What are the traditions that had a purpose in the past, but won’t help us in the future?”
For Fidelity to thrive, it will have to deal with trends cutting at the heart of its business. Active management is being supplanted by ETFs and other low-cost index products. Advisory fees are under pressure as young investors opt for ETF-based robo services, while commissions for brokerage services erode across the board. Getting more young people to invest is a huge challenge as millennials leave college and start careers with record levels of student debt.
Fee compression has become so prevalent that Fidelity had no choice but to join in. The firm trimmed equity-trading commissions from $7.95 to $4.95 last year and recently launched four zero-fee index mutual funds. The company has also cut fees on mutual funds, lowered investment minimums, and taken other steps to retain and attract cost-conscious investors.
“Fee compression has been part of our life for years, and it’s hard to see a lot of reasons why it changes,” Johnson says. “The bet now is on the rate of change—does it lessen a little?” Industry consolidation will keep pressuring fees, as fewer firms control more assets and use their technology and economies of scale to lower prices, she adds.
Price cuts helped lift retail trading volume to 295,000 daily trades last year, a 21% jump from 2016. But how long can Fidelity hold out at $4.95? Even that looks excessive now that investors can trade commission-free on Robinhood, an online platform and app with more than five million customers and a $5.6 billion valuation (based on recent funding round). Vanguard no longer charges commissions to trade most ETFs (leveraged and inverse products are notable, and admirable, exceptions). JPMorgan Chase (JPM) recently launched an app, You Invest, offering 100 commission-free trades in the first year that customers sign up.
Executives at Fidelity, including Johnson, say that free trading isn’t really free. Costs that aren’t transparent may include a broker’s payment for order flow, resulting in poorer trade execution and “price improvement.” Fidelity, Johnson says, is “committed to getting best execution, and that’s why our customers continue to trade with us.”
A bigger challenge may be stopping the exodus out of Fidelity’s actively managed mutual funds. Fidelity’s active stock funds had outflows of $47 billion in 2017 and $58 billion in 2016, according to the firm’s annual report. Over the past decade, active stock funds lost more than $281 billion in assets due to outflows, according to Thomson Reuters.
The losses appear to be slowing, part of a broader slowdown in the movement of active to passive. But Fidelity can’t argue that it’s happening to everyone: American Funds had net flows of nearly $40 billion into its active funds in 2017. Fidelity’s active equity mutual funds, meanwhile, have lost assets despite strong showings from two of its premier stock pickers, Will Danoff at Fidelity Contrafund (FCNTX) and Steve Wymer at Fidelity Growth Company fund (FDGRX). The funds hold $183 billion in assets, nearly 10% of Fidelity’s $1.98 trillion in active assets.
Fidelity’s outliers don’t make up for mediocre performance across its fund universe, says David Snowball, co-founder of the Mutual Fund Observer newsletter. According to data from Morningstar, he notes, only 53 of Fidelity’s 122 diversified U.S. equity funds (43%) produced above-average returns over the past 12 months. Just 7% beat their peers over the prior one- and three-year periods. The numbers don’t look much stronger for international equity, taxable bond, or municipal bond funds over the past year.
Fidelity slices the data more favorably. The firm says that its mutual funds beat 78%, 77%, and 76% of peers for the trailing one-, three-, and five-year periods, respectively, and that all major divisions—including high-yield, fixed-income, and global asset allocation—outperformed their benchmark indexes in 2017. Actively managed stock funds stood out, Fidelity says, beating their indexes by an average of more than 4 percentage points, the best performance since 2009.
Fidelity’s numbers look stronger than Snowball’s analysis for two reasons. The firm aggregates everything, including money-market and multiasset funds, into its overall performance figures. And results are asset-weighted, “reflecting the proportion of assets maintained in large funds,” according to its annual report. That skews the figures to big funds that have done well, such as Contrafund and Growth Company. Moreover, when a fund outperforms in the first half of the year, it often sees strong inflows in the second half, skewing performance further in favor of asset-weighted figures, says Snowball. “The number will look better on an asset-weighted basis because it carries biases,” he says. Based on his analysis, Snowball says a random sampling of funds would outperform at a similar rate. Fidelity’s performance “is not immediately evidence of galactic dominance.”
The beauty of Fidelity’s revenue model is that its funds can underperform and shed assets without taking down the mother ship. Asset management had net inflows of $24.1 billion last year, as separately managed accounts raked in $37 billion, more than enough to offset asset losses in funds. “Fidelity could exit actively managed funds tomorrow and would be just fine,” says Jack Bowers, a financial advisor and publisher of the independent newsletter Fidelity Monitor & Insight.
Fidelity.com has become a hub for multiple revenue streams. Retail trading commissions, Barron’s calculates, may produce $365 million a year in revenues, based on average daily volume of 295,000 transactions (not including options). Fidelity charges distribution fees to fund companies for shelf space on its platform. And Fidelity is capitalizing, mainly indirectly, off ETFs. Investors can buy 240 iShares ETFs commission-free on the site (along with Fidelity’s own ETFs). ETF fee revenues flow to iShares parent BlackRock. But the free-trading benefit helps drive sales of other products and new accounts, says Kathleen Murphy, president of Fidelity Personal Investing. Fidelity may also get a cut of the ETF fees or “other compensation” from BlackRock as the business grows, she says.
None of this sets Fidelity apart from other brokers or asset managers. But Fidelity has woven itself so deeply into the corporate fabric—administering retirement plans and other benefits—that it should emerge stronger in the aftermath of a bear market that would take down firms more dependent on AUM fees, proprietary trading, or other market-based revenue sources. During the 2008-09 meltdown, Fidelity came out relatively strong, says Lowell. “The Johnson family has always been like China in some ways. They have five- and 10-year plans.”
Fidelity’s workplace division is a case study in its evolution beyond fund management. As the largest record-keeper of 401(k) plans, Fidelity has amassed $2 trillion in assets on its platform, covering more than 29 million account holders. Its managed-account business is the fastest-growing in the industry, according to Cerulli Associates, with AUM that have doubled over the past three years to almost $36 billion. More than 400,000 workers use these retirement accounts, five times the number from five years ago, Fidelity says.
Record-keeping tends to be a low-fee business. But 401(k) assets are “sticky,” and the relationships with both employers and employees open pathways for Fidelity to sell other products, such as individual retirement accounts, target-date funds, payroll, and managed accounts. “We view ourselves as the front door to the customer,” says Kevin Barry, president of workplace investing. “Most customers have their first experience with Fidelity through the workspace.”
The prize is getting target-date into 401(k) plans as qualified default investment alternatives, or QDIAs. Almost all plans default to target-date funds as QDIAs for auto-enrolled investors, creating a built-in and growing customer base. Plan sponsors that use Fidelity as a record-keeper aren’t obliged to select its funds. But record-keeping isn’t free; administrators like Fidelity charge fees per participant or strike revenue-sharing deals with fund companies (which could be in-house funds) to defray costs to the plan sponsor. That’s where sales and deal making can help nudge a record-keeper’s funds into a plan. “If a client starts a relationship with Fidelity, it may lead to broader discussions on fund selection, and if Fidelity has solutions, it can lead to that,” says Barry. “If Fidelity funds are in the investment lineup, they can be a source of [cost] contributions.”
Fidelity’s target-date Freedom Funds could use the sales help. The funds went through a 10-year stretch of underperforming internal benchmarks until 2014, when performance started to improve as they increased equity exposure, according to an analysis by Reuters. Despite a strong foothold in the 401(k) market, Freedom Funds had nearly $16 billion in net withdrawals from 2014 through 2017. The funds now hold $229 billion in assets, and flows turned positive in 2017 with inflows of $5.3 billion, according to Thomson Reuters. But money is still heading out the door, with $1.3 billion in outflows so far this year.
Fidelity spends $2.5 billion a year on technology, with a workforce of “10,000 technologists around the globe.” The results aren’t apparent in whiz-bang features like virtual-reality tools or computer-generated financial advisors—yet. But it drives down operating costs and pays off in the background. Many registered investment advisors choose to custody assets with Fidelity because its platform works so well, says Lowell. Fidelity isn’t a tech disrupter, he adds, but “among the major financial houses, it’s one of the most tech-oriented and progressive.”
Fidelity develops much of its own financial tools, apps, and trading technology in its incubator, Fidelity Labs. On a recent visit to the Labs, the firm showed off augmented-reality goggles that it’s developing for 3-D charting. A team was working on a Bitcoin service (tightly under wraps) that Johnson says she “hopes to have commercially available by the end of the year.”
If Fidelity does launch a digital-coin exchange, it would, as is often the case, not be the first. In February, Robinhood started offering commission-free trading in Bitcoin and other cryptocurrencies, now allowed in the 17 states. An exchange called ErisX, backed by TD Ameritrade Holding (AMTD) and Virtu Financial (VIRT), recently announced plans to trade digital currencies and related derivatives. ETFs may be coming soon: The Securities and Exchange Commission is weighing whether to approve nine Bitcoin-related ETFs over the next few months.
Fidelity investors can see Coinbase balances on Fidelity.com and donate digital currency to the Fidelity Charitable Donor-Advised Fund. And the firm is experimenting internally. Some company cafeterias accept Bitcoin as payment, and a Bit & Blocks club (2,600 members connected with Fidelity’s blockchain incubator) sponsors an annual Crypto-Asset Portfolio Challenge for employees (using hypothetical currencies).
One thing Fidelity learned? Hardly anyone uses Bitcoin to buy lunch because the currency could appreciate so fast that a pizza could end up costing the equivalent of $50 by the time you’ve finished eating. The firm also found out how easy it is for computerized cryptocurrency traders to beat people: Indian programmers developed trading bots for the in-house contest, prompting Fidelity to put constraints on the strategy.
Bitcoin, says Abby, is an “extracurricular activity for me.” But she’s well versed in the lingo. “You start hashing the blocks and hope to hit one first, which is when you mine your coins,” she says, describing the mining operation. Fidelity dipped into mining Bitcoin, through a small venture launched in 2015. “This was Fidelity writing a check to buy a bunch of computer equipment,” says Johnson. “We expected to lose money on it. But we were making ridiculous amounts of money at the peak.” Fidelity is exploring more “use cases” for Bitcoin, she adds, while waiting for federal regulators to issue more trading, tax, and anti-money-laundering rules.
Can Fidelity continue to go it alone while the industry consolidates and its rivals bulk up? With actively managed mutual funds slowly eroding, one could argue that an index provider such as MSCI (MSCI) would be a good fit, or an ETF sponsor like WisdomTree Investments (WETF). But Johnson dismisses the idea. “It’s not very exciting to go buy something that we’re pretty confident we could do ourselves,” she says, noting that Fidelity is doing more “self-indexing” for its own ETFs and funds.
Aside from a few minor deals—such as its purchase of a software business, eMoney Advisor, in 2015—acquisitions have never been part of Fidelity’s growth strategy. What about issuing debt or using its equity as currency for a major acquisition? “We’re much better at doing things organically,” Johnson replies. “The calculation of doing an acquisition if you’re a private company, versus a public company that can pay for an acquisition with stock, is very different,” she adds. “You’re more discriminating about price when it’s your own money.”
Of course, the other big question is who will take over when she retires. Will her daughter, Julia McKown, a trainee in Fidelity’s “Emerging Leader” program, become the fourth-generation Johnson family member to run the firm? “I have no idea,” Johnson says. “Charlie’s making himself available,” she jokes, referring to Charlie Morrison, head of asset management, who sits in the conference room. It’s an inside joke: Morrison announced his retirement 10 days later.
Fidelity public relations executives at this point urge Johnson to conclude the interview. But Barron’s lobs one more question: Is there a succession plan? “Yes,” Johnson replies before standing up to go, “and it’s not discussed publicly.”