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What's Going on With Fidelity and American Funds?

Two articles crossed my desk within a day of one another this past week, and together they speak volumes about the state of the mutual fund industry today.

The first, entitled "Fidelity Funds Bled $49.3 Billion Last Year," highlighted the continuation of a trend I wrote about last year -- Fidelity's negative cash flow. Hard as it may be to believe, Fidelity's actively managed equity funds haven't taken in more investor assets than they've lost since 2004 -- a staggering six year streak for the best-known firm in an industry that has traditionally seen very strong cash flow.

The second article, carrying the headline "Equities Rally Excludes American Funds," described how February marked the 20th consecutive month that American Funds has seen negative cash flow, which is itself an amazing dry spell for a firm with legions of brokers pushing their funds.

The numbers described above might represent a paradigm shift in the mutual fund industry. That Fidelity and American Funds are the second- and third-largest managers in the mutual fund industry does not do justice to their relative importance.

From 1990 through 2004, Fidelity and American Funds dominated the industry's cash flow, taking in $27 of every $100 that was invested in actively managed equity funds. In the six subsequent years, their actively managed stock funds have seen a net outflow of -$6.8 billion, while the rest of the industry has seen net inflow of $166 billion.

Zoom in a bit closer, and the problems are even more evident. Since 2007, Fidelity's and American Funds' actively managed stock funds have suffered from $175 billion in outflow, representing two-thirds of the outflow of the entire industry.

And even in the past year -- as industry cash flow has started to recover from the recent bear market -- the two firms' problems have continued. Together, Fidelity and American Funds have seen $62 billion of investor cash leave their stock and bond funds, while the remaining 50 largest fund managers have taken in nearly $130 combined.

So why is it that two of the industry's largest, most well-known fund managers have been shrinking while the rest of the industry has been going in the opposite direction?

As you might expect, fund performance might play a role. Over the past decade, the general equity funds of these two firms have been rather mediocre. American Funds' offerings have combined to return 3.8 percent per year, while Fidelity's have provided a 3.9 percent annual return, both of which are nearly indistinguishable from the broad stock market's 3.9 percent annual return in that period.

And while that record isn't terribly disappointing on a relative basis, it's not the sort of record that catches investors' attention, particularly when the firms' primary point of differentiation had been their ability to outsmart the markets.

But that performance hardly makes them unique in the industry, which is why it probably doesn't fully explain why Fidelity and American Funds are losing market share.

A second explanation is that since the recent bear market, mutual fund investors seem to be losing patience with actively managed domestic equity funds. Over the past year, for instance, investors have pulled $48 billion out of domestic stock funds, while putting $70 billion into domestic equity ETFs, according to Morningstar.

In other words, Fidelity and American Funds reaped outsized rewards -- and cash flow -- when investors accepted the industry's traditional raison d'être. Now that that is coming under increased scrutiny, those same firms are on the bleeding edge, suffering the consequences.

Fidelity has been suffering those consequences for the better part of a decade, seeing their actively managed funds lose market share to index funds among self-directed investors. American Funds is just beginning to feel the effects, as the brokers who traditionally recommended their funds to investors in the past are now increasingly open to using ETFs to build their clients' portfolios. The brokers, based on anecdotal evidence, are tiring of having to explain why last year's fund pick was a loser and why this year's will be a winner, and view ETF-based portfolios as a great way of avoiding those conversations. (This isn't to suggest that these past fund pickers are fully on the indexing bandwagon, for there's ample evidence that shuffling money among asset classes via ETFs in an attempt to add value is merely replacing the shuffling of money among actively managed funds.)

So what's next for Fidelity and American Funds? We'll have to wait to see how the latter adapts, but Fidelity's plan is apparent, as the bulk of their advertising is dedicated not to touting individual funds, but their financial planning and brokerage services.

But lest you worry too much about their fate, rest assured that both firms seem to remain abundantly profitable. In spite of suffering from years of net cash outflow, Fidelity reported last week that their operating income rose 17 percent to $2.94 billion, which is reportedly one of their best years ever. And while a similar figure for American Funds is not available, it's reasonable to believe -- based on a similar total asset base of stock and bond funds -- that their profits are in the same ballpark.

So the bad news for these firms is that the model that served them so well for so long seems to be slowly crumbling beneath them. The good news is that it appears likely that they have years' worth of multi-billion dollar profits ahead of them as they attempt to find their place in a shifting mutual fund industry.

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