Fidelity Investments has long had a top-down mandate to invest in technology for competitive advantage. The economic slowdown hasn’t changed a thing.
By Steven Brull
March 2002
Institutional Investor Magazine
Deep in the snowy woods of southern New Hampshire, in a low-slung structure that blends seamlessly into the landscape, sit row upon row of computers and data storage units. Masked by the whir of cooling fans, a maelstrom of unseen activity rages. The hard drives spin. The servers purr. They are processing stock, bond and mutual fund transactions by the millions. On a typical day, orders totaling 5 percent to 8 percent of all New York Stock Exchange trades pass through these systems.
This building in Merrimack, New Hampshire, and a similar one nearby form the hubs of a major operations center belonging to mutual fund behemoth Fidelity Investments. They are also what the world’s largest mutual fund company is betting the future on.
Technology needs and advances have reshaped finance. Firms live and die on their ability to trade faster, handle customer requests more cheaply and process enormous amounts of financial data more efficiently than their rivals can. To keep pace, major banks, brokerage firms and investment shops must invest staggering sums on hardware, software and programmers. Last year, even as they cut costs to battle market downturns, Citigroup spent $5.1 billion to keep its brokers, bankers and ATMs wired; Merrill Lynch & Co. poured $2.2 billion into technology; and Charles Schwab & Co. burned through $650 million.
Fidelity may not be the financial world’s biggest tech spender, but it ranks among its most rabid believers. Fidelity spends about 25 percent of its revenue on technology, compared with about 15 percent at Charles Schwab and about 5 percent at Merrill Lynch. And despite a severe slump in the mutual fund business last year, Fidelity increased its annual tech spending from $1.9 billion to $2.3 billion - a 21 percent rise at a time when many rivals were cutting their budgets or holding percentage increases to single digits. What’s more, Fidelity reports that its tech spending has increased for five straight years and that it has spent $8.7 billion over that period.
The Boston-based firm’s commitment to technology extends beyond just its budget. In June 2000 it appointed as vice chairman and chief operating officer former institutional chief Robert Reynolds, who never picked a stock in his life but is respected for having built the firm’s 401(k) business into a technology powerhouse. Even company chairman and CEO Edward (Ned) Johnson III, whose family controls 49 percent of the voting stock of Fidelity’s parent, FMR Corp., is said to spend hours picking over the details of Fidelity Web sites.
“Johnson’s the head technologist,” says Steven Elterich, president of Fidelity EBusiness and principal architect of the company’s Web initiatives.
Fidelity’s fixation on technology springs first from a deep-seated conviction that electronic finance has only just begun to revolutionize the mutual fund and brokerage businesses, and that Fidelity can gain an edge on competitors by harnessing and exploiting innovations. The Internet is already pervasive operationally - two thirds of customer contacts occur online - and culturally - senior managers talk incessantly about how integration of products and distribution channels will drive down costs and increase customer satisfaction and loyalty. Fidelity also pours millions into its Fidelity Center for Applied Technology, or FCAT, a 67-person unit that develops and tests new technologies and studies ways to improve the design and navigability of the company’s Web sites.
Because Fidelity is privately held, it can keep expenditures up without jeopardizing quarterly earnings targets for public shareholders. And among the financials that Fidelity chooses to disclose is the fact that a technology-driven business - employee benefits services - accounts for 25 percent of revenues. (Fidelity has not yet announced its 2001 revenues, but David O’Leary, president of Alpha Equity Research in North Hampton, New Hampshire, estimates that they were $8.8 billion and that net income was breakeven.)
Indeed, Fidelity’s boldest strategy is its push to spin new businesses out from its technology backbone. The most successful of these is employee benefits services, a 1990s outgrowth of Fidelity’s giant 401(k) business, which runs back-office administrative processing for plan sponsor companies. Fidelity is betting that this nitty-gritty outsourcing business will be a big, long-term money-spinner. “What mutual funds meant to the growth of Fidelity in its first 50 years, benefit outsourcing can mean to the next 50,” says Reynolds. He believes that the business could contribute more than half of Fidelity’s total revenue by the end of this decade.
Although benefits outsourcing is relatively new, the secretive, closely held company’s willingness to take a flier on technology is not. Fidelity has regarded it as a strategic weapon since the 1960s, when top management concluded that customer service would rank just behind fund performance as the key factor in attracting and keeping assets. “We brought the servicing of our customer base in-house and became very involved in technology,” says Reynolds, 50, who spent four years building the benefits outsourcing business before he was named COO in 2000. “What’s important is a willingness to commit significant sums of capital to build a business.”
To be sure, some skeptics question just how profitable Fidelity’s benefits business is and whether it could really stand apart from the company’s vast money management operation. They view outsourcing as a low-margin gambit for Fidelity to increase its funds under management. “Fidelity’s vision has been to get a hold of money at payroll, even if it means getting into a low-margin business,” says one competitor. But Fidelity executives insist that benefits outsourcing can be lucrative by itself, especially when economies of scale can be exploited. “We can raise the ante a lot, and with a lot less pain than anyone else,” says Reynolds.
Fidelity, through its venture capital arm, has also invested in dozens of start-up and existing technology firms. One of its higher-profile holdings is Colt Telecom Group, which it formed in 1992 to provide high-speed communications between offices in London. Colt - originally an acronym for City of London Telecommunications - went public in 1996 and now provides services in 32 cities in 13 European countries. Affected by overcapacity in the telecommunications industry, Colt lost £360.4 million ($525 million) on revenues of £905.7 million last year. Fidelity’s initial $150 million stake in Colt was worth $13 billion when the stock price peaked in March 2000; Colt’s valuation has since fallen more than 95 percent. But Fidelity late last year demonstrated its long-term commitment by investing an additional £286 million, increasing its stake by 6.3 percentage points, to 54 percent.
Ideally, returns on technology and venture capital investments can offset cyclical declines in the core business. And there has been an unmistakable slowdown in mutual funds. After the growth explosion of the 1990s, most people with money to invest are already fund customers, and the vast majority of big companies are offering 401(k) retirement plans. Fidelity’s assets under management fell about 4 percent last year, to $883 billion. Net new fund sales in the U.S. totaled $35.2 billion. In the squeeze, Fidelity cut 760 jobs, or about 2 percent of the total workforce, mainly in the telephone customer service area.
But given the inherent volatility of venture investing, as reflected in Fidelity’s experience with Colt, piggybacking new services on the money management business may be a more reliable way of ensuring steady growth. “Even when markets return to growth, the industry might not come back too fast,” says Russel Kinnel, director of fund analysis at Morningstar in Chicago. And that has Fidelity counting on technology more than ever.
Fidelity cut its technology teeth in the brutally competitive 401(k) business. The firm began offering administrative services to defined contribution plans in 1986 and has since grown to become the industry leader with more than 22,500 companies, 10 million individual participants and $371 billion under management. The business required a heavy investment in recordkeeping services. As the number of clients grew, Fidelity put money into developing automated voice response systems and advanced workstations for phone representatives - all aimed at keeping a sharp competitive edge. “Their ability to aggregate and then incorporate and disseminate information is phenomenal,” says Jim Lowell, publisher of the “Fidelity Investor” newsletter, which tracks Fidelity funds.
With the emergence of the Web in the mid-1990s, Fidelity began to see new applications for its 401(k) processing and servicing infrastructure. As Internet technology intrigued corporate America as a way to cut human resources and benefits-administration costs, for example, Fidelity in 1995 began handling defined benefit plans and health and welfare services. In 1998 it expanded into payroll processing, and last year it added employee stock plan services and workplace 529 savings plans. Today Fidelity provides outsourced benefits services to more than 200 companies with 1.6 million participants, a figure that has more than doubled since 1999. No other mutual fund company has moved into outsourced benefits, but Fidelity is competing against benefits specialists such as Hewitt Associates and CitiStreet, a joint venture of Citigroup and State Street Corp.
Hughes Electronics Corp. has been relying on Fidelity since 1997, when it was in the process of selling its defense interests to Raytheon Co. El Segundo, California-based Hughes, the parent of DirecTV, was seeking a new 401(k) administrator to replace Hewitt Associates for its 7,000 employees. As is the case with 60 percent of the requests for proposals for 401(k) services that Fidelity receives, Hughes also wanted to outsource medical insurance, pensions, payroll and other operations. Shifting to Fidelity, says Sandra Harrison, Hughes’s corporate senior vice president for human resources and administration, “allowed us to cut corporate administrative staff, but what’s most important is that everything is integrated online and that employees can do everything in one place.”
Integrating a host of benefits is not a trivial task. An employee transferring to a new location, for example, can trigger changes in salary, retirement contributions and eligibility for medical, dental and vision plans. The extent of the changes would depend on the specifics of the location, the employee’s status, company-specific rules for 401(k) contributions and other benefits, the contours of health insurers’ coverage areas and other variables.
A central database coordinates Fidelity’s separate systems for retirement savings, medical benefits and payrolls. It updates these systems and transfers the information to insurance carriers, plan administrators and employees.
The complexity of the technology needed to service a client base totaling 17 million is evident at the New Hampshire facility’s Internet Operations Center, where engineers track network performance on a 40-foot-wide wall blanketed by computer monitors. On one of the approximately 20 screens along the wall, color-coded lines show the speed of major arteries of the Internet across three continents. On an average day these systems interact with 545,000 customers and transmit more than 8 million Web pages in six languages.
If there is a common refrain around Fidelity, it’s “integration.” The holy grail is to tie all products - mutual funds and brokerage, corporate retirement and benefits offerings - together with all distribution channels - the Web, telephones and offices - on a single infrastructure. “Our value proposition is being able to offer a point of integration on the Web and the phones that brings things together in one place for employees,” says Peter Smail, president of Fidelity Employer Services Co., or FESCo, the unit responsible for outsourcing services to other institutions.
Fidelity’s operation is an ongoing experiment in integration: On the floor above the Internet Operations Center and in the adjacent building, hundreds of representatives field questions coming in over the phones and via e-mail. The callers tend to be people who are inundated by online information and want easy access to tools and data that can help them navigate stormy markets to achieve financial goals. “It’s easy to put things up, hard to make use of them,” says Dan Burke, director of brokerage services at Gómez, a Waltham, Massachusetts, research firm that rates online consumer businesses. “Firms that can marry investment expertise with usability expertise are going to win.”
And as big as the Internet has become - 87 percent of Fidelity’s commissionable brokerage trades and 55 percent of mutual fund transactions are initiated on the Web - people still want to speak to human beings. “Our reps are doing more consultative calls regarding asset allocation and investor education,” says John Begley, the executive vice president who runs FESCo’s call centers.
The man most responsible for Fidelity’s technology culture is Ned Johnson, the son of Fidelity’s founder. Ever since he bought the company’s first mainframe computer in 1965, Johnson, who became president in 1972 and chairman and CEO in 1977, has been intimately involved in technology. “He knows more about some areas of technology than anyone in this company,” says Fidelity EBusiness president Elterich.
People who know Johnson say he’s both practical and conceptual. “When you talk to him about technology, he talks about the future in the present tense,” says Robert Hegarty, a director at TowerGroup, a financial industry research and consulting firm in Needham, Massachusetts, who worked at Fidelity from 1990 to 1998. “His mantra is the practical deployment of advanced technology.” Recognizing that new technologies don’t come cheap, Johnson is willing to spend money on the latest tricks. “Johnson’s question always is, Are we spending enough, are we going fast enough?” says COO Reynolds.
Fidelity’s willingness and ability to spend give it considerable clout with vendors, opening up opportunities for joint development projects and preferential pricing, not to mention glimpses at new gadgets and machinery before many others have the privilege. “They’re not shy about using their leverage in the marketplace,” says TowerGroup’s Hegarty. “They lean on all the technology providers - hardware, software, communications companies, service companies and systems integrators. They lean on them not solely to drive down costs but to create a partnership that allows them to deliver more advanced technology.”
Fidelity, for instance, is jointly developing software for human resources management with Oracle Corp. And servers from IBM Corp. sit idle - and unpaid for - in the Merrimack operations center, ready for action when there is a spike in demand. “They’re all set up, but the engines are not turned on,” explains Elterich. “We can get them online in 30 minutes, and then we start to pay.”
Fidelity’s weight also helps it to shape technical standards for the financial services industry; it has, for example, actively supported the research information exchange markup language, or RIXML, which promises to streamline the distribution and management of securities industry research. “Fidelity has traditionally played a leading role in the establishment of standards in the financial industry,” says Alexander Hungate, chief executive of global marketing for Reuters Group. “We are very lucky to have a close relationship with them.” But collaborating with Fidelity can be a double-edged sword: “They can help you develop new products, but they’re demanding as hell,” says Hegarty.
Fidelity boasts a series of technology firsts: In 1974 the first use of toll-free numbers to market funds directly to consumers; in 1979 the industry’s first automated telephone voice response system; in 1984 computerized trading; in 1995 the first mutual fund Web site; in 1999 the first real-time quotes and trades over a wireless device, the RIM 957, which was a precursor of Research In Motion’s BlackBerry pagers. In 2001 it became the first financial services firm to offer customer account information to cars equipped with General Motors Corp.'s OnStar system.
Recently, Fidelity has been focusing tech resources on the retail brokerage business, where Schwab, E*Trade Financial and others have been fierce online competitors. Technology, says Elterich, “is not a part of that business; it’s become the business.”
In the past 12 months, Fidelity has streamlined its home page and introduced instant messaging to connect investors quickly with service representatives. It also rolled out a new version of Fidelity.com, its main retail site, for interactive-television users, which the company believes will attract a small but growing cadre of older, high-net-worth individuals. Behind the scenes, the company improved the response time of Fidelity.com by two seconds.
Fidelity believes that its recent investments have helped it gain ground on Schwab, the securities firm it is often most closely compared with. “Schwab and Fidelity continue to wrestle each other,” says Burke at Gómez, which ranked Schwab and Fidelity almost even in its fall 2001 assessment of top Internet brokerages. “Both companies are excellent,” adds John Michel, who ran Merrill Lynch Direct until last year, when he became president and CEO of Bullrun Financial, a Princeton, New Jersey-based portfolio management software company. “The contrasts are around the edges.”
In the competition to service intermediary distributors of its funds, Fidelity has been unable to displace Schwab from its leading position. “Fidelity has got great technology, but other things around it - such as service and brand - are more important,” says Michel.
Fidelity does not just look inward at its own operations and competitive edge. The mutual fund giant’s tradition of in-house development, in synergy with the Fidelity Capital investments arm, has also spawned a host of new companies.
In 1996, for instance, Fidelity bought Advisor Technology Services, a struggling provider of back-office applications for trust companies. Fidelity plowed money into the operation, whose technology is now used in-house as well as in about a quarter of the largest U.S. bank holding companies. And in August 2000 Fidelity Capital funded InterOPS, a start-up using technology developed for Fidelity’s Internet Operations Center to manage the online operations of other financial services companies. It was co-founded by Christopher McLellan, who designed and managed the IOC.
Of course, it was easy to love technology in the 1990s.
One dot-com crash later, many major financial firms are gaining a new appreciation of the risks and costs that go along with the moments of dramatic upside. Though financial industry technology spending remains fairly steady, the drumbeat about the capabilty of technology to revolutionize finance has certainly faded.
Not so at Fidelity, which revels in its privately held independence and vows to stay the course. Even in the middle of a mutual fund slump, it still owns perhaps the greatest franchise in one of the financial world’s most lucrative businesses. When it comes to technology, it pays to be a believer.
“With the Web there was a lot of talk about first movers, grab this, grab that,” says COO Reynolds. “That’s important. But what’s more important is whether you are spending to build a good long-term business.”
