Why Fidelity Wants You to Replace These ETFs

Brokerage companies want your money, and they know that the key to investors' hearts right now is in providing exchange-traded funds at no commission. Yesterday, Fidelity and ETF partner BlackRock (NYSE: BLK  ) greatly expanded their commission-free ETF lineup, answering previous moves from rival brokers. But in doing so, Fidelity and BlackRock made life a little more difficult for their existing clients, pressuring them to replace ETFs that are already in their portfolios. Let's take a closer look at the deal and the history behind it.

Answering the call
Fidelity's move comes in response to heightened competition among its industry peers. Just last month, Charles Schwab (NYSE: SCHW  ) made a big expansion of its own free-ETF line, going beyond its own proprietary ETFs to pull in a number of funds from No. 2 provider State Street (NYSE: STT  ) and its popular SPDR line of ETFs, as well as several other ETF providers. With a lineup of 105 commission-free ETFs, Schwab moved itself ahead of TD AMERITRADE (NYSE: AMTD  ) and its 101-member roster of no-fee ETFs.

Fidelity didn't go quite as far as Schwab, expanding the number of commission-free offerings from 30 to 65. But with the power of BlackRock's industry-leading iShares unit, the ETFs made available to Fidelity investors will allow them to do a much better job of filling out their diversified portfolios than the previous offerings did.

Before and after
Before the switch, the 30 ETFs that Fidelity offered were heavily concentrated in domestic stocks, with 17 funds for every combination of market cap and investing style, including growth, value, and dividend investing. Six international funds, six fixed-income funds, and one real-estate fund rounded out the list.

Now, though, the offerings are more well-rounded. There are only 16 domestic stock funds, but they eliminate duplications and have more specialty funds, including the S&P US Preferred Stock ETF (NYSEMKT: PFF  ) , which gives exposure to income-producing preferred shares. International funds have gotten beefed up considerably, with 20 ETFs in both developed and emerging markets along with some specialty funds. On the fixed-income side, 25 ETFs now give exposure to Treasuries, corporates, municipals, and international bonds. Four commodity-oriented funds that include mining and agriculture stocks round out the list.

An annoying task for existing Fidelity customers
These new ETFs will make it possible for investors to tailor their ETF portfolio a lot more closely to their overall needs. But for me, the most surprising thing about the move is the fact that some ETFs that were previously offered commission-free are not on the list of 65 ETFs going forward. Among the funds being replaced are the highly popular iShares MSCI EAFE (NYSEMKT: EFA  ) , iShares MSCI Emerging Markets (NYSEMKT: EEM  ) , and iShares Russell 2000 (NYSEMKT: IWM  ) ETFs.

It's not that these funds don't have replacements among the 65; they do. Moreover, the replacements are largely cheaper than the funds they replace, which is a good thing for investors. But the shift also forces investors who've already taken advantage of Fidelity's commission-free ETF offerings to make a choice: either take advantage of a grace period to sell existing holdings by July at no commission and then buy their new counterparts, or accept the need to pay commissions if they sell out after the grace period ends.

With zero commissions, the first alternative may not sound too bad. But if you have capital gains on the ETFs that are being kicked off the list, you'll have to realize those gains on your tax return if you sell in order to adjust your portfolio to the new commission-free list. Moreover, the move raises the possibility of what could happen if Fidelity and iShares decide to adjust their portfolios again at some point in the future.

A mixed bag
With the complications involved for existing customers, what should have been an unqualified positive move from Fidelity becomes an example of how the economics of the partnerships between ETF providers and brokerage companies trump client treatment. iShares might get a benefit from pushing investors into less-followed funds, even though its fee income will likely shrink from the move. Yet existing investors get left with a troublesome chore in order to adapt. That's not the kind of customer service experience that Fidelity should want to give its customers, even if new ones will benefit from the greater breadth of its ETF offerings.

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