Bankers Trust Co. bested its competitors by snagging a deal to manage three Fidelity Investments indexed equity mutual funds - with $11.4 billion in assets - and three new index funds.
Industry sources said Fidelity conducted a limited search among the top three or four index fund managers, choosing Bankers Trust because it made what one source called "a really, really excellent deal."
By outsourcing management of its passive equity mutual funds, Boston-based Fidelity hopes it can keep management fees low enough to compete with its chief rival, The Vanguard Group of Investment Cos., Malvern, Pa.
The deal has the added advantage of allowing Fidelity to focus on its primary business, active money management.
If shareholders approve the deal this fall, New York-based Bankers Trust will manage the $7.3 billion Spartan U.S. Equity Index; the $2.7 billion Spartan Market Index; and the variable annuity option, the $1.4 billion VIP II: Index 500 Portfolio.
Bankers Trust also will manage three equity mutual funds, slated for a fall 1997 launch, based on the Wilshire 4500, the Wilshire 5000 and the Morgan Stanley Capital International Europe Australasia Far East Index.
Frank Minard, chairman of Bankers Trust's U.S. investment management activities, said he approached Fidelity's Gary Burkhead, then president and chief executive officer of Fidelity Management & Research Co., in January. They proposed a deal to manage Fidelity's indexed mutual funds cheaper and better than Fidelity could do it, he said.
Bankers' courting of Fidelity is part of its year-old effort to attract new subadvisory index fund business, primarily from active managers. The firm has picked up such business from Scudder, Stevens & Clark Inc., New York; Variable Annuity Life Insurance Co., Houston; AMR Investment Services Inc., Dallas-Fort Worth Airport; and USAA Investment Management Co., Dallas.
Fidelity began to get serious about the idea of outsourcing index fund management in April, when Robert Pozen was promoted to president and chief executive officer of Fidelity Management & Research Co., and assumed responsibility for all investment management activities.
Mr. Pozen said he took a fresh look at how Fidelity handled passive money management because it was expanding beyond basic Standard & Poor's 500 Index funds
"When we wanted to expand our index fund offerings, I realized that it was going to take a major commitment of people and capital and not just on the money management side, but also in the areas of securities lending and custody. This (passive investment) is not a business we're in and it's not one we want to be in. But indexed management is cyclical and it's in favor now. We need to give our clients what they want and now, they want index funds," said Mr. Pozen.
Because passive management is a commodity business, he said, "we decided to go out and find the lowest price provider we could. We chose Bankers Trust because it offered the most attractive bid, a combination of low price and quality. And in Bankers Trust's case, it also had the two important components needed to provide index management very inexpensively: strong securities lending capabilities and a high volume of business."
Mr. Pozen stressed Fidelity has "absolutely no plans" to hire any other outside managers.
Mr. Minard said he couldn't talk about the cost structure of the Fidelity deal and what Bankers Trust is charging for its services, but confirmed the deal "is a very good one."
Other bidders not revealed
No one interviewed would reveal who the other bidders were, although data from Pensions & Investments show the biggest players besides BT are Barclays Global Investors, San Francisco, and State Street Global Advisors, Boston.
Tim Harbert, president of SSGA, declined comment on whether his company bid for Fidelity's business. Patricia Dunn, co-chairman of Barclays Global Advisors, said it was up to Fidelity to comment on the companies they interviewed.
Fidelity executives would not reveal specifics or identify the other firms reviewed.
Fidelity's effort to find an indexer "was not unlike what a plan sponsor would undertake in choosing an investment manager," said Robert Reynolds, president of Fidelity Institutional Retirement Services Group.
Bankers Trust's Mr. Minard said Fidelity "did a tremendous amount of due diligence. Teams of people came to Bankers Trust and looked over much more than just our money management capabilities .*.*."
Mr. Minard said three factors likely clinched the deal for Bankers Trust: its low trading costs; its $2 trillion worldwide custody business; and its securities lending capabilities, particularly in the small-capitalization and international portfolios it manages. Bankers Trust handles $230 billion in securities lending business.
Fidelity's decision impressive
Industry observers were uniformly impressed by Fidelity's decision.
The deal has "great goodness of fit on both sides" and is a "real reflection of a strong strategy move for both Bankers Trust and Fidelity," said Jim Johnston, a managing director at money management consultants Paradigm Partners International L.L.C., West Hartford, Conn.
"The agreement eliminates the disintermediation within Fidelity between the active and passive management sides of their business. It allows them to preserve their active management strengths and still offer a very reasonable passive product.
"Bankers Trust's unit costs are so low now, that in aggregate, it allows them to offer Fidelity a very good deal," Mr. Johnston said.
David O'Leary, president of Alpha Equity Research Inc., Portsmouth, N.H., and a former Fidelity employee, agreed about the significance of separating active and passive.
"For psychic reasons, Fidelity's top management is physically distancing the active fund managers from the passive index funds. The performance of the market indexes have been so good, relative to Fidelity's active managers' performance, that it has forced those managers to be constantly looking over their shoulders. Fidelity's management no longer wants them to be able to look over and see index fund managers right there in the office," he said.
"I think with Fidelity it may have come down to the issue that passive management just didn't belong in their active shop," said Avi Nachmany, a consultant at Strategic Insight Inc., New York.
Competing with Vanguard
Hiring Bankers is one of several ways Fidelity can compete more aggressively with Vanguard.
In April, Fidelity lowered the management fee for the Spartan U.S. Equity Index Fund, an institutional fund, to 24 basis points from 28. The management fee for the retail Spartan Market Index dropped to 24 basis points from 45.
In order to capitalize on the current demand by investors for index funds, Fidelity also capped temporarily the total expense ratio (management fees plus other advisory fees) at 19 basis points for both funds.
By providing short-term discount pricing for the S&P 500 equity index funds, Fidelity hopes to attract new assets as well as satisfy customer demands for a cheaper pricing structure, said Mr. Pozen.
The new Wilshire 4500 and 5000 funds each will carry a management fee of 24 basis points, although they, too, will be subject to a temporary cap that holds the total expense ratio to 25 basis points. The new EAFE fund will carry a 34 basis-point management fee, with the same temporary cap on the total expense ratio of 35 basis points.
But the 19 basis-point fee on the Spartan funds "is not viable long-term," said Mr. Pozen. With Bankers Trust, however, Fidelity can take advantage of BT's economies of scale to make sure Fidelity can offer competitively priced index funds on a long-term basis, he said.
"We'll look at the situation at the end of 1999 and see whether or not we'll be able then to lower the management fees on the index funds," he said.
Vanguard's management fee for its retail S&P 500 Portfolio is 17 basis points, plus 3 basis points in additional fees, for a total expense ratio of 20 basis points. Data from Strategic Insight shows the average management fee for an S&P 500 mutual fund is 19 basis points and the average total expense ratio is 38 basis points.
Is pricing low enough?
But Fidelity's S&P 500 index funds lose their competitive edge for 401(k) plan and other institutional investors when compared to what Vanguard charges for its Institutional Index Fund - a total expense ratio of just six basis points for plans with more than $10 million.
Even Fidelity's indexed commingled funds, which are used exclusively by 401(k) plans, are more expensive than Vanguard's.
Satisfying defined contribution plan clients is one of the primary drivers behind the Bankers Trust deal, said Fidelity's Mr. Reynolds. "We can see that in the future a lot of 401(k) plan sponsors will want to put passive and active investment options side-by-side in their plans," Mr. Reynolds said.
Consultant John Mulligan at Retirement Plan Strategies, Boston, said Fidelity's realization that it has competition in one of its primary revenue streams - from retirement plans - might have come too late.
"Fidelity saw that their client audience had become very clearly based in the retirement plan segment and that the audience's needs were changing. The audience wants index funds. You could argue that Fidelity is acting too late in bringing better, cheaper index funds to their clients.
"You could take a shot at them for that. But you've got to hand it to them. It takes a lot for a company the size of Fidelity to admit that they're going to make a change in the fundamental way they've always managed client money - by hiring an outsider," Mr. Mulligan said.
Fidelity will continue to manage internally about $10 billion in S&P 500 indexed commingled funds, all for 401(k) plans; about $20 billion in enhanced index strategies, mostly for defined benefit plans; and a $577 million indexed bond fund.
Bankers Trust manages $233 billion worldwide and $190 billion in passive strategies. Its own mutual fund efforts in the U.S. market pale in comparison with its index management monolith, with just about $10 billion under management for U.S. clients, of which $2.3 billion is in indexed mutual funds.