* Fidelity expenses surge on new investments
* Total net outflows decline to $5.3 billion
* Vanguard widens lead over Fidelity
BOSTON, Feb 15 (Reuters) - Fidelity Investments on Friday said profit in its financial services business dropped 29 percent in 2012 as customers pulled $24.4 billion from the company's actively managed stock funds.
Fidelity's 2012 results also showed asset growth that severely lagged archrival Vanguard Group, the No.1 U.S. mutual fund company.
While Fidelity's assets under management rose 10 percent to $1.67 trillion, Vanguard's assets surged to $2 trillion, a 20 percent increase over 2011. Assets under management at BlackRock Inc, the world's largest money manager, rose 8 percent to nearly $3.8 trillion in 2012.
Vanguard and BlackRock have undercut Fidelity's market position with index and exchange-traded funds that are cheaper than Fidelity's stable of stock funds, such as Contrafund and Magellan. Customers continue to pull billions of dollars out of Fidelity stock funds, despite showing a steady improvement in performance in recent years.
Fidelity, however, said that in 2012 it splurged on new strategic investments, including build out of an exchange-traded fund business that is getting a late start against BlackRock's iShares division and Vanguard. Fidelity said operating expenses surged 9 percent to $10.3 billion in 2012.
Fidelity Chairman Edward C. Johnson III, whose family controls Fidelity, said in his annual letter that one of the advantages of private ownership is investing in the company even at the expense of current profits.
"This has served us well in the past, and I am confident it will continue to do so," Johnson said.
Last year, he promoted his daughter, Abigail Johnson, to be president of Fidelity Financial Services, putting her in charge of all of Fidelity's major lines of business for the first time. She is positioned to succeed her father as the head of a firm founded by her grandfather, Edward Johnson II. Forbes magazine has estimated her wealth at $10.3 billion.
Fidelity is still a profit machine, with 2012 operating income of $2.3 billion, compared with $3.3 billion in 2011. The results exclude diversified businesses and investments outside of Fidelity's core financial services operation. Fidelity's homebuilding supply business, ProBuild, has required large capital infusions in recent years to cover losses.
Fidelity said its financial services revenue fell 1 percent last year to $12.63 billion.
"Pricing pressures, extremely low interest rates, lower trading volumes and continued outflows from actively managed equity funds contributed to the revenue decline," Fidelity said in its annual report.
Investors and financial advisers favored low-priced, passively managed index funds in 2012, playing to Vanguard's historic strengths.
But across the mutual fund industry, active equity funds - Fidelity's historic bread-and-butter business - had $119 billion in outflows as investors continued to favor bonds as well as index and ETF products.
Outflows in Fidelity's own actively managed stock funds improved, but only slightly from the $26.9 billion in outflows recorded in 2011. Overall in 2012, net outflows of $5.3 billion improved over 2011's outflows of $36.3 billion at Fidelity.
The improvement reflects net flows of $17.3 billion into bond products and $14.8 billion into asset-allocation products, Fidelity said.
Meanwhile, Fidelity's own ETF business barely registers on the investment landscape, as BlackRock, State Street Corp and Vanguard solidify leading positions in the marketplace. Those three managers combined for about 84 percent of the U.S.-listed ETF market. BlackRock had $561 billion in ETF assets, followed by $319 billion at State Street and $246 billion at Vanguard.
In December, though, Fidelity filed an application with the U.S. Securities and Exchange Commission to operate actively managed bond and stock ETFs.