Fidelity’s Select Funds vs. ETFs: The Verdict
Exchange Traded Funds (ETFs) have surged in popularity because they trade continuously like stocks, and because their fees are low. But many investors are not aware that these repackaged index funds do not have the ability to outperform their benchmarks. They work fine if all you want to do is mimic the performance of the S&P 500 or the price of gold, but when it comes to sector investing there is no free lunch. The tradeoff for continuous inter-day trading is likely to be uninspiring long-term performance.
It’s been three years since Fidelity realigned its sector benchmarks, allowing all ten of its broad-based Selects to be compared directly to Vanguard’s sector ETF lineup. Let’s take this opportunity to see how they’ve done.
The S&P 500 declined at a compound rate of 5.4% annually over the three years ending 9/30/09 – a period that was anything but easy for actively managed funds. Redemptions were heavy in the wake of the financial crisis, forcing managers to unload stocks into a market with poor liquidity. Then in early 2009, stocks turned on a dime and began roaring back, causing funds that held cash to lag. If there was ever a time that sector ETFs should have had an advantage, this was it.
But as it turns out, actively managed Selects held their own, despite adverse conditions. On average they were able to outperform their Vanguard ETF counterparts by 1.2 percentage points per year, with only 3 out of 10 finishing the period behind their passive alternatives.
This kind of performance is not unusual for the Fidelity Selects. During the same three year period, 31 out of 39 sectors finished ahead of the S&P 500. Only 20% of the population lagged the broad market index.
ACTIVE MANAGEMENT DONE RIGHT
The Selects are living proof that the efficient market theory is flawed. Since 1981, these funds have been successful even while doing the opposite of what financial “experts” say is most important. Many of them have been run by first-time managers whose tenures were on the short side. Portfolio turnover has always been high, and expense ratios were not exactly low. Yet somehow, the Selects have often prevailed on the performance front.
How has Fidelity pulled it off? In a word, research. Fidelity’s small army of analysts have always been determined to get the latest story, and get it right. Over the years, these workaholics have kept tabs on thousands of companies, putting in long hours to fully understand industry business models. In each sector, they know the trends, the competitors, the risks, and the major factors that influence the bottom line.
This kind of proprietary research is easily able to overcome other less-important factors. Expense ratios don’t have to be rock bottom, because the money Fidelity spends on stock research tends to pay back many times over in the form of improved performance. High portfolio turnover actually helps when it’s driven by research, because decisions are the result of new insights, rather than a reaction to being in the wrong place at the wrong time. And manager tenure is less important, because all managers are set up for
success.
SELECTS IGNORED BY THE PRESS
It’s amazing how much press coverage is devoted to ETFs, while the Select family is all but ignored. The media mantra: look for low expenses, low turnover, and managers that don’t try to reduce risk or improve performance.
These pundits, having harped on this philosophy for decades, have become blind to actively-managed success stories like the Selects. Part of their problem is a focus on short-term performance. To fully appreciate the advantage of good research, you have to look back over a period of ten years or more.
Not many ETFs have been around that long.
At Fidelity, where sector managers appear to have the stockpicking odds skewed in their favor, the idea that investors should walk from any fund with an expense ratio of more than 0.25% is almost laughable. Rather than questioning whether it makes sense to have a research department, the financial press should be focusing instead on the return generated for each research dollar spent.
Unfortunately, for those who have adopted the ETF belief system, the real cost of kissing off actively managed funds may not become obvious for years to come. In order for sector ETFs to maintain liquidity, they must focus mainly on large cap stocks and leave small-cap opportunities to others. That’s good news for Fidelity, where the small-cap exposure is the tailwind that gives the Selects their long-term edge. Not only is it the place where good research makes the most difference, it’s also where earnings growth rates
are highest.
To be sure, ETFs can do some things better than mutual funds. These investment vehicles can purchase commodities directly, mimicking the price of gold, silver, oil, and other hard assets. It doesn’t cost as much to start up an ETF, making it possible to offer foreign country indexes and unique index strategies that wouldn’t be profitable in a mutual fund format. And for better or for worse, ETFs let you use leverage to magnify your gains or losses – without any need to qualify for a brokerage account allowing margin and short-selling.
But these types of ETFs are often used by individuals who don’t really appreciate the difference between investing and gambling, and the results are like what you would expect after a weekend in Las Vegas. You may occasionally leave with more money than you had to begin with, but more often than not your money ends up in the pockets of others.
For disciplined long-term investors, we believe that a fully-invested approach with Fidelity Selects will compare favorably with ETFs over time.