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Fund Times: Fidelity Fines Itself

Plus, Vanguard Bond ETFs, First Trust pulls the old switcharoo, and more.

Morningstar Analysts, 12/21/2006

Fidelity traders who received improper gifts from brokers directed trades to those brokers, an investigation by the independent trustees of Fidelity's fund board has concluded. But the trustees couldn't find proof that investors were harmed.

The trustees' investigation was prompted by ongoing NASD and SEC investigations into "travel, entertainment, gifts, and gratuities," including Super Bowl tickets and various junkets, given by brokers to Fidelity traders. Even though the trustee investigation didn't prove that the misdirection resulted in higher trading costs for the funds, they nonetheless recommended that Fidelity Investments pay a $42 million fine to Fidelity funds. Fidelity chairman Ned Johnson took the unusual step of posting a letter on Fidelity's Web site in response. He apologized for the behavior, acknowledged that the funds were put at risk, and agreed to pay the fine.

The irony of this more than two-year old trading scandal is that Fidelity has been a leader in bringing down trading costs, the benefits of which have flowed to fund shareholders. Fidelity has used its huge trading volume as negotiating leverage over Wall Street. Fidelity has driven down brokerage commissions and struck groundbreaking deals with brokers like Lehman Brothers and Deutsche Bank to pay for research out of its own pocket, "unbundling" it from brokerage commissions. We viewed this as a shareholder-friendly step, as "soft dollar" arrangements, which are still commonplace in the mutual fund industry, force fund investors to pay excessively high brokerage commissions, when research costs should come out of an advisor's management fee.

Since the scandal broke, we have been encouraged by Fidelity's handling of the allegations. An internal corporate investigation found that traders violated internal policies prohibiting employees from "giving or accepting any gift, worth more than $100 per calendar year, to or from any person or entity who is a current or prospective vendor, customer, or supplier of Fidelity." Fidelity disciplined 14 traders, firing some. Scott DeSano, the subject of considerable media attention for his efforts to drive down commissions, is no longer the head of equity trading. And Fidelity has tightened its policy regarding gifts. The fact that independent trustees, who are entrusted with advocating for shareholders, launched an investigation (paid for by Fidelity) was encouraging.

Still, we await the findings of the SEC and NASD investigations into whether shareholders were harmed and whether Fidelity should pay additional fines.

Vanguard Plans to Offer Fixed-Income ETFs
Vanguard has been a big player in the rapidly growing ETF market, but thus far, it's stuck to equity ETFs. That could be about to change. In October, the fund family filed with the SEC for permission to create ETF share classes for Vanguard Total Bond Market VBMFX, Vanguard Short-Term Bond Index VBISX, Vanguard Intermediate-Term Bond Index VBIIX, and Vanguard Long-Term Bond Index VBLTX.

It's anyone's guess when these bond ETFs will hit the market, given that the SEC must first grant exemptions from the Investment Company Act of 1940 before Vanguard can formally register them. There are a couple of things investors should expect when they do arrive, though. Vanguard is known for its low expenses, and its ETF share classes are generally priced below the Admiral share classes of the parent funds. In this case, the Admiral share classes of the parent bond funds charge about 0.11%, so these ETFs will likely be cheaper than their closest fixed-income ETF rivals from iShares, which charge between 0.15% to 0.2%. Also, the parent bond funds are well diversified and own more securities than the iShares rivals. That should help the proposed ETFs hew closer to their respective indexes. Finally, since the parent bond funds track indexes with exposure to government, corporate, and agency bonds, these ETFs will cover more ground than the iShares ETFs, whose indexes include only Treasuries.

Vanguard to Launch New International Index Fund
In the first quarter of 2007 Vanguard also hopes to launch what is essentially a new total international stock market index fund and ETF.

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