With the industry reeling from a scandal, the fund heavyweight goes on the offensive.

(FORTUNE Magazine) – ON THE MORNING OF JAN. 14, 2003, MUTUAL FUND EXECUTIVES across the country turned to the editorial page of the Wall Street Journal and promptly choked on their morning coffee. They found a piece by Edward "Ned" Johnson III, the patrician chairman of Fidelity Investments, blasting a regulatory proposal that would force fund companies to disclose how they voted in company proxies. What was shocking about the editorial was not only that Johnson's co-author on the piece was his archrival John Brennan, chairman of the Vanguard Group, but also that it marked one of the few times in his career that the secretive Johnson has gone public with his views.

Since then, the nation's largest mutual fund company (with $850 billion in assets) has been full of surprises. Earlier this year Johnson penned another column attacking an industry rule change. Meanwhile his lieutenants have launched a campaign against the 212-year-old New York Stock Exchange and pressured Wall Street securities firms to sharply reduce their commissions. For its part, Fidelity's discount brokerage unit is slashing online trading charges to grab market share. And this fall its mutual fund business cut the fees on its $42 billion in index funds--a right hook aimed straight at Vanguard, the industry's dominant power in indexing. Says Jim Lowell, editor of the Fidelity Investor newsletter: "This is the most aggressive I've seen Fidelity be in the last 25 years."

In part, Fidelity is simply defending its turf, but it is also moving to exploit the scandals that have engulfed the financial markets since the stock market bubble burst in 2000. (Fidelity declined to make any of its executives available for this story.) In the mutual fund arena, that means grabbing assets from tarnished peers. On Wall Street, that means pushing big brokerage firms and the New York Stock Exchange for changes that suit its own agenda. "I think Fidelity realizes the entire financial services industry is in turmoil and, essentially, up for grabs," says Don Cassidy, senior research analyst at fund tracker Lipper. "As one of the biggest players in several of these markets, they have a lot at stake."

And a lot of advantages. Fidelity's sheer size gives it unmatched leverage in its dealings with big Wall Street brokerage houses. Fidelity also gets an edge from being a private company, controlled by the Johnson family. (Ned Johnson, 74, holds 12% of the voting stock and his daughter Abigail, 42, head of the mutual fund group and heir apparent, holds 24%.) With no nervous shareholders to answer to, Fidelity's executives can make bold strategic moves, invest millions in new technology or marketing, and wait patiently--sometimes for years--to reap the rewards. Fidelity spent $20 million in the 1980s developing its corporate 401(k) retirement-service business, which took nearly a decade to turn a profit. Today Fidelity is the largest 401(k) provider in the country. Says Merrill Lynch research analyst Guy Moszkowski: "If Fidelity decides, for instance, that its retail brokerage business is a strategic priority and that it may take some losses or make unattractive profit margins for a while in order to build market share, it has shown it can--and will--do just that." Fidelity is a dangerous foe indeed.

FOR DECADES, GATHERING ASSETS IN THE mutual fund industry was as easy as holding a bucket in a rainstorm. America's thriving middle class wanted to save for its future, and that was the audience the mutual fund industry targeted. Between 1988 and 2000, the number of American households that owned a mutual fund doubled, to about 48%. Net new cash flows into equity funds in the 1980s and 1990s surged, hitting a frenzied peak in 2000, when investors plunked more than $309 billion into stock funds alone.

By then Fidelity had firmly established itself as a brand name--the Coca-Cola, if you will, of the industry. It built its reputation as the best actively managed stock fund family in the 1980s on the gun-slinging style and outsized returns of managers like Peter Lynch, who headed up its flagship Magellan Fund. Those stunning performance records plus its aggressive marketing push helped Fidelity take a commanding position in the new 401(k) retirement business. And it's a sweet business indeed: signing up a new corporate client brings in thousands of new customers who invest millions of dollars that arrive automatically month after month.

But as Fidelity grew, the performance of many of its brand-name funds seemed to suffer. Critics charged that the funds had become too big--Magellan alone had $54 billion in assets in 1995--to be managed effectively. Then, partly in response to Jeff Vinik's controversial move into bonds at Magellan, Fidelity took steps to rein in its managers. Performance continues to be so-so; while some of Fidelity's biggest funds are holding their own (see box on the following page), the recent record of many funds is less than inspiring. In 2002, 55% of its equity funds beat their peers, according to Chicago fund-tracking group Morningstar. That percentage dropped to 50% last year, and so far this year only 34% of Fidelity's stock funds are beating their peers. (For our selection of seven outstanding funds from smaller companies see "The Best of the Bantamweights.")

The industry scandal that unfolded last fall proved far more worrisome than subpar investment results. On Sept. 3, 2003, New York attorney general Eliot Spitzer announced that his office had launched an investigation into questionable trading activities at some of the nation's most respected fund families. It turned out that the companies had cut special deals with hedge funds and other big investors, allowing them to make after-hours trades and dozens of rapid-fire moves in and out of their funds, and sometimes providing confidential information about fund holdings.

For its betrayal of investors' trust, the industry has paid a high price. Fund families lost billions of dollars in assets as individuals and institutions withdrew their money from firms caught up in the scandal. Founders and executives at some of the nation's most prestigious houses, including Alliance Capital, Janus, Putnam Investments, and Strong Capital, were ousted. So far, more than a dozen fund companies accused of wrongdoing have coughed up more than $2.6 billion in fines, restitution, and fee reductions. And that number will continue climbing as new incidents come to light. "It wasn't a case of a few bad apples," says Don Phillips, a managing director at Morningstar. "The industry had a major ethical problem on its hands."

INSIDE THE HALLOWED HALLS OF FIDELITY, Johnson watched as the industry's crisis of confidence threatened to affect his beloved firm. It was time to go on the offensive. He posted a piece on the company's website feistily defending the fund business and declaring that Fidelity, at least, didn't take shareholders' trust for granted. "Ned was one of the first in the industry to come out and say that the scandal was not a good thing, but that he felt Fidelity was well run and that there weren't any serious problems there," says Donald Dion, editor of the Fidelity Independent Adviser newsletter. "Ned's lawyers were probably telling him to shut up, but at least he had the balls to come out and take a stand."

Johnson was already hopping mad over officials' plans to force mutual fund companies to disclose how they voted in corporate proxies. Now he worried that the SEC, embarrassed that it was Spitzer who uncovered the chicanery in the fund business, would issue a raft of new rules. In another open letter to Fidelity shareholders, he cautioned that any changes in the industry must be "carefully thought through." He then went on to quote Lyndon Johnson: "Any darn mule can kick down a barn."

Johnson was right about one thing: Starting last winter, the SEC introduced nearly a dozen new rules--representing the most sweeping changes in the industry's 60-year history. Johnson was especially enraged by proposals on fund governance. Each mutual fund has its own board of directors, which is supposed to protect the interests of the shareholders. It is the board that approves the fees the investment advisor gets for managing the fund. In theory the board even has the power to fire the funds' management company and hire a different one (a power that is almost never exercised). Some observers contend that if fund boards had been doing their job, the market-timing and other abuses never would have happened.

In hopes of making boards more effective, the SEC proposed requiring that three-quarters of the board (up from the current majority) be independent, including the chairman. At Fidelity, that role has always been filled by a member of the Johnson family. In fact, Ned Johnson currently chairs all of Fidelity's 300-plus funds. (The new rule would not affect his position as chairman of Fidelity and its investment advisory arm.) Johnson has fought hard, lobbying and penning more angry editorials. ("I don't believe [this proposed rule] protects shareholders' interests. In fact, I worry it may do the opposite," he wrote in the Wall Street Journal this past February. "It is an idea which on the surface is so simple and appealing that it's downright dangerous.") However, this looks like one battle he's going to lose: The rule change is expected to go into effect in 2006.

BUT FIDELITY PLANS TO WIN THE WAR. A FUNNY thing happened as the mutual fund industry came under attack: Fidelity benefited. As investors fled fund groups implicated in the scandal, they went looking for a trustworthy place to park their money. The biggest winners by far in this reshuffling were American Funds (run by Los Angeles--based Capital Research & Management) and Vanguard. But Fidelity, which had seen new cash flows to its equity funds drop precipitously in the late 1990s, suddenly had a huge spike in inflows for 2003 and again in 2004.

At the same time, Fidelity began to target the New York Stock Exchange, which itself was in the midst of one of the biggest shakeups in its long history. Regulators had pounced on the NYSE after an investigation revealed some floor traders--called "specialists"--at the exchange had traded stocks ahead of their customers for years. Then the flap over CEO Richard Grasso's multimillion dollar pay packages put even more pressure on the exchange. (For more see "The Fall of the House of Grasso" on

Fidelity jumped into this battle with both feet. It launched a public campaign to change the rules governing the institution itself. Fidelity, which alone accounts for 3% to 5% of the NYSE's daily volume, argued that it should be able to execute more of its trades on faster and cheaper electronic exchanges, which would reduce its costs and boost shareholder returns. It promises to be a bloody struggle. Fidelity has become a four-letter word--and it's not Fido--among the brokers and specialists working on the floor of the NYSE who see its crusade as a challenge to their livelihood. ("I sold all of my Fidelity funds and told my family to do the same," one floor broker remarked to FORTUNE this summer.)

Fidelity followed that offensive up this March in a letter to the SEC attacking the use of "soft dollars." Most Wall Street firms charge mutual funds about 5 cents a share to trade stocks. (Fidelity says it has pressured most of its brokers to cut that to about 3.5 cents a share.) But only part of that commission goes toward the cost of executing the trade. The rest--the "soft dollars"--pays the broker for providing research, market data, and other services that the fund company uses, but which may not directly benefit fund shareholders. In effect, the shareholders are helping defray the fund company's overhead. Last year Fidelity estimated that of the $815 million its stock funds paid in commissions, about $160 million went for soft-dollar services.

Now Fidelity says it intends to change that practice. It wants its brokers to charge separately for trades and other services. But Wall Street is resisting. Brokers say that if they are forced to unbundle commissions, their trading profit margins will shrink to almost nothing. Fidelity, though, is pressing ahead. For example, it has begun paying for market data services such as Bloomberg terminals out of its own pocket rather than passing the cost on to investors. It estimates that alone will save fund shareholders $40 million to $50 million a year. (A few other fund companies, notably MFS, which is run by former Fidelity executive Robert Pozen, have announced similar initiatives.)

Fidelity is also asserting itself through its discount brokerage unit. In early October it announced plans to change the way bonds are sold. In place of hidden fees and markups--standard industry practice--Fidelity will charge low, fixed commissions. Many observers say the firm can't make money selling Treasury and municipal debt that way. Rather, the move appears to be part of a plan to lure customers from Wall Street firms. Fidelity has also been cutting the commissions it charges for online stock trades to stay competitive with rival brokers like Charles Schwab.

Indeed, the new mantra inside Fidelity seems to be that there are no sacred cows. The house that was built on the belief that smart stock pickers can consistently beat the market threw that credo out the window this fall. That's when it slashed fees on its index funds in half to ten basis points ($1 for every $1,000 invested). The move is clearly a broadside directed at Vanguard, which has long sold the idea that market returns at a low cost beat gambling on the skill (or luck) of stock pickers, the vast majority of whom underperform year after year. Vanguard manages $300 billion in index funds and charges ten to 18 basis points annually on its Vanguard 500 Index fund. The irony of Fidelity's competing for a bigger share of that business is not lost on John Bogle, Vanguard's retired founder. "Johnson never thought any investor would be satisfied with ... just keeping up with the market," he says. "Fidelity has seen the writing on the wall and that there's a lot of money going into index funds." Fidelity says it will lose about $39 million in revenues this year from the fee reduction.

Of course, the entire industry will most likely have to deal with a future of lower income and more modest profit margins. Thanks in part to Spitzer's push, management fees are coming under pressure. Meanwhile the costs of complying with new rules and disclosure requirements will raise expenses at most fund companies. (For example, all firms will need a compliance officer.) Boston's Financial Research Corp. estimates profit margins for the industry could be squeezed from current levels of 36% to 19%.

Clearly the large asset managers, as they continue to gobble up a bigger chunk of investors' savings, will easily absorb these new costs. And small firms will still be able to carve out a comfortable niche. But managers of midsized funds trying to match the breadth of service of the big boys will have to tighten their belts. "There will always be a place for boutique money management firms," predicts Vanguard's Brennan. "But for companies with less than $75 billion or $100 billion in assets under management, it's going to be very tough to be fully integrated and full-service. It's going to be hard to compete against the American Funds and Fidelities of the world." Indeed, taking on Fidelity never has been easy. And it's going to get a lot tougher.