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The $400 billion behemoth from Boston has started to slip. Can Ned Johnson's famous money machine get back into high gear?
It was a battle of money-management titans. In one corner stood the reigning champion, Fidelity Investments. In the other, five pesky rivals vying to break Fidelity's dominance of the fastest-growing segment of the financial-services industry--the $675 billion 401(k) market. The clash was over the management of retirement assets for the employees of Toro Co., the Minneapolis-based manufacturer of lawn mowers and snowblowers. At the end of a painstaking selection process last year, the champ was dealt a knockout blow. Gerald T. Knight, Toro's chief financial officer, says Fidelity lost out to the smaller Putnam Investments because its funds were too erratic and unfocused. "Our employees are not very sophisticated investors, and we needed very consistent and very disciplined funds," he says.
Inconsistent? Undisciplined? That's hardly a description befitting the world's most famous investment machine. Fidelity's considerable stock-picking prowess has produced the most remarkable growth streak in the annals of finance. The company is taking in nearly $5 billion a month. It has 10 million individual fund shareholders, controls 13% of all the money in mutual funds, and still wins its share of 401(k) customers, including General Motors, Ford, and AT&T. The company has expanded into virtually all aspects of financial services, including underwriting, brokerage, insurance, and credit cards, and it is aggressively pushing offshore versions of its funds in Europe and the Far East. Its long tentacles have helped double its assets in the past three years, to $400 billion.
But Toro's decision is emblematic of enormous challenges facing the Boston-based giant. As money has gushed in, many of its largest funds have been taking ever-bigger bets, straying farther from their basic objectives and spooking a growing number of institutional investors such as Toro. Compounding Fidelity's problems is evidence that size is beginning to hinder its funds. Managers are finding it increasingly difficult to maneuver their huge holdings in and out of the stock market. The performance of its $56 billion flagship Fidelity Magellan Fund has been erratic, and the performance of its domestic equity funds overall has been slipping for two years.
BUNKER MENTALITY. At the same time, Fidelity's prominence has led to an extraordinary level of scrutiny. On Apr. 19, The Washington Post reported that the Securities & Exchange Commission is investigating the personal trading activities during 1993 of seven current and former Fidelity fund managers, including Jeffrey N. Vinik, who runs the Magellan Fund. Fidelity called the report "flat-out wrong" and posted a statement on its Internet World Wide Web site calling the story a "rehash of old stories that also were inaccurate." The SEC took the unusual step of issuing a statement saying the report "contains inaccuracies which have led to erroneous impressions." Two years ago, the SEC reviewed personal trading records of Fidelity, and no action was taken.
More worrisome to Fidelity is how Vinik handled the selling of Magellan's $1 billion position in Micron Technology Inc. in late 1995. The star manager has been sued by Micron shareholders, and the SEC is looking into whether Vinik manipulated the stock. The most serious charge: He publicly talked up Micron in press interviews at the same time he was unloading it. Fidelity denies Vinik did anything wrong, but Barry P. Barbash, director of the SEC's investment-management division, said last December that the allegations "raise questions" under the antifraud provisions of the 1934 Securities Act. The incident has created a bunker-like atmosphere at Fidelity. Managers have been barred from discussing specific stocks with the press, and executives refuse to talk about numerous aspects of their operations, fearing their disclosures will be used in future lawsuits.
No matter how the Vinik affair turns out, Fidelity has reached a critical juncture. Its business was built largely on individual investors looking for high returns. But the consumer market Fidelity dominates is slowing down industrywide. Last year, more than half its new cash came from 401(k) plans, making it essential that Fidelity please those customers. And like Toro, many companies are much less interested in short-term results than accountability and predictability. "They invest in anything they want, and they take all kinds of risks," says Robert B. Clelland, president of Robert J. Metcalf & Associates Inc. in La Jolla, Calif., which advises companies on mutual funds. As a result, Clelland doesn't recommend any Fidelity funds to his clients. Says Toro's Knight: "We want small-cap funds that invest in small-cap stocks and bond funds that invest in bonds."
HOLDING FIRE. Chairman Edward C. "Ned" Johnson III, who has led the privately held firm since the early 1970s, declined to be interviewed. Sources say the 65-year-old billionaire has been involved in reshaping his funds, but he has left the details to underlings while pursuing other Fidelity business. He recently returned from a trip to the Far East and Britain, where Fidelity has been rapidly expanding. His decision to allow his top aides to ride herd over the funds reflects the gradual transition of power taking place at Fidelity. In 1994, he gave his 34-year-old daughter, Abigail, a fund manager, a 24% stake in the company--equal to his own--and last year distributed 51% of the voting stock to employees.
The senior executives who oversee funds are all likely to take on larger roles when Johnson retires--though the chairman has not indicated when that will be. They include President and Chief Executive Officer J. Gary Burkhead, Chief Operating Officer William J. Hayes, and former Magellan manager Peter S. Lynch. These executives say major efforts are under way to better manage the firm's growth and regain its performance edge. Johnson has long believed in the Japanese management philosophy of kaizen, or continuous change, so there is no specific blueprint. But the changes are among the most extensive Fidelity has undertaken in years.
Inside Fidelity, efforts to tame its funds have triggered a controversial overhaul of its investment operation, some of which has gone unnoticed outside the company. It has reassigned fund managers, completely reversed course in its bond department, implemented new risk-control measures, and taken steps to refocus funds. Some think the changes are choking fund managers and reducing the chances they'll be able to achieve their historically high returns.
"We used to be like fighter pilots," says one former high-ranking fund manager. "We used to go in every morning, strap on our helmets, and go in with guns blazing." But no more, say sources close to the company. Fidelity executives strongly deny they're stifling their fund managers. But it's clear the company is charting a new course.
Some fixing seems necessary. Of course, Fidelity managers have traditionally been encouraged to take risks and to defy the conventional wisdom. During 1995, for instance, nearly all of Fidelity's diversified growth funds had more than 30% of their assets in technology stocks--a huge bet that was paying off until the tech stocks sank in the fourth quarter. A number of other popular funds, including Fidelity Asset Manager Fund and Fidelity Blue Chip Growth Fund, were hurt by investments many didn't even expect would be in the funds (table, page 106).
Indeed, the performance of Fidelity's domestic equity funds--the core of the company--has been slipping. The Magellan Fund has beaten the benchmark Standard & Poor's 500-stock index only once in the past four years and is badly lagging the market this year (1.8% vs. 5.4% for the S&P 500 as of Mar. 31). Among the 10 largest fund companies (excluding money-market funds), Fidelity's returns rank second for the 5- and 10-year periods ending Mar. 31 (table, page 105), beating the other nine companies' average by nearly two percentage points a year (chart, page 110). For the last three years, Fidelity ranks third but beats the average by only one percentage point. Over the past 12 months, Fidelity did no better than fifth--and earned a return that was just average. Two years ago, when Morningstar Inc. last conducted this study for BUSINESS WEEK, Fidelity was first in all but the one-year period. But even then, it was beating the average of its peers by two percentage points.
How Fidelity manages its spectacular growth will have major consequences for the company's customers--and the $3 trillion mutual-fund industry as well. "Fidelity and Magellan are in a special position of representing the mutual-fund industry," says William Goetzmann, an associate professor who teaches investing at Yale University's School of Organization & Management.
POWER COMPUTING. To improve returns, Fidelity is spending big bucks on investment infrastructure. Last year, the equity research staff was boosted 17%, to 162 analysts, who now track 4,900 companies, up from 3,800 in 1994. The company also spent $51 million on computers for investment research and trading operations, up from $31 million in 1994. One powerful new technology launched last year is a computerized trading system that links Fidelity with more than 100 brokerage firms. "It has been invaluable in providing liquidity for our funds," says Robert H. Morrison, head of equity trading.
Even more significant, Fidelity has shaken up its portfolio managers. Burkhead reassigned 18 managers of Fidelity's 26 weakest funds, moving other Fidelity managers into those slots. The idea, says Burkhead, is to align managers' investment styles with the goals of their funds. One example: Michael Gordon, who bought small companies for Fidelity Blue Chip Growth Fund, was switched to the Fidelity Retirement Growth Fund, which is more suited to his fondness for small-cap stocks. Says Burkhead: "We need to have funds in different categories play specific roles."
Fidelity started the changes last year by radically transforming its bond funds, which performed poorly in 1994. Its bond managers had unsuccessfully tried to swing for the fences like the equity managers by stoking their funds with derivatives, currencies, and Third World debt. But now they use "targeted active management"--also known as benchmarking--in which funds follow a tightly defined set of permissible investments. "No more big bets," says Fred L. Henning Jr., director of fixed-income investments.
Then, in January, Fidelity replaced the managers of its most aggressive bond fund, Capital & Income, who specialized in buying debt in bankrupt companies, taking seats on the creditor committees, and actively trying to increase the value of the holdings. The former managers had made increasingly problematic investments, including a nearly 50% stake in El Paso Electric Co. that got the fund involved in negotiating electric rates with Texas regulators. Says Burkhead: "It came down to a choice between continuing to run the fund as it had been or not violating our longstanding principles" of being passive investors.
Behind the scenes, Burkhead has quietly implemented new risk-management controls. Investments in emerging markets--once frequently used by managers to goose performance--are subject to a liquidity "framework," presumably designed to ensure that funds can sell the holdings quickly if need be. Burkhead has also added a risk-management department to develop new ways to measure the safety of fund investments, including evaluating liquidity concerns when the funds make big bets. Burkhead refuses to discuss any details of the new risk-control schemes or how managers will use them to guide their funds. One thing seems clear: He's trying to avoid nasty surprises.
Burkhead is also trying to cut down on the pack mentality that led so many managers into the same stocks. Late last year, sources say, he halted the internal distribution of "daily night sheets" listing the prior day's trading records of all portfolio managers. Some ex-managers say this data enabled them to piggyback gn one another's trading. If a manager spotted a buying or selling trend in a stock, he or she could do the same, riding a trend that Fidelity managers may have created just by the weight of their money. Fidelity won't comment on the daily sheets, except to say they raised "security concerns." Says an evasive Burkhead: "We think what we're doing will be very powerful for our shareholders."
MORALE TROUBLE? Several former managers think Burkhead is scuttling the risk-taking bravado that defined Fidelity and boxing its portfolio managers into corners. "The risk-control element was never there before," says one source. Now, says another, the changes are hurting morale among some managers.
Burkhead insists the critics are wrong. "We're not getting more conservative," he says. He says funds that are designed to be aggressively managed, including Magellan, will not change. Robert E. Stansky, manager of the $6.8 billion Fidelity Growth Company Fund, denies he is any less aggressive. "If I thought it made sense to put 40% of my fund in retail [stocks], I would do it in a minute," he says.
It's precisely those big bets that have Fidelity critics up in arms. For instance, last year, Vinik had as much as 46% of Magellan in tech stocks. This year, he has 19% of his assets in bonds. "Putting 40% of any fund into one sector is not diversification," says William F. Sharpe, Stanford University professor and winner of a Nobel prize in economics for his work on investment theory. "And shifting a substantial portion of assets from stocks to bonds is market timing, and Magellan is not a market-timing fund."
SIMPLE MATH. The firm defends Vinik's strategy. "Peter Lynch did the same thing, and no one criticized him," gripes William J. Hayes, chief operating officer for equity investments. When Lynch ran Magellan, he made big sector bets with great success. For instance, in 1985, Lynch put 28.6% of the fund into financial stocks. Magellan that year was up 43.1%, vs. 31.7% for the S&P 500.
In the past two years, Fidelity's big funds have not achieved such market-beating returns. To some degree, that's a result of stock-picking. But another important issue is size. Evidence suggests that magnitude may be a problem for Fidelity's largest funds. In three of the past four years, Fidelity's growth funds with less than $1 billion in assets outperformed its growth funds with more than $5 billion.
Lynch argues that size doesn't have anything to do with it. He attributes the sagging results to the company's investment style being out of sync with the market. "We tend to look for turnarounds and value in small- and midcap stocks, and that's not where the market has been the past two years," he says. Most of the gains have come in large-company stocks that Fidelity has considered overvalued, he says. Adds Stansky: "It all comes down to whether you make the right bets."
A number of former high-ranking fund managers say that's only partly true. "There are a lot of structural reasons why [the large funds are] going to underperform," says one source. Says another departed manager: "They're so large that significant outperformance [of the market] is going to be impossible."
It's simple mathematics. A neat $10 million profit on an investment adds a full percentage point to the return of a $1 billion fund, but it adds less than two-tenths of a percent to Magellan's return. This fact puts an enormous burden on managers of Fidelity's larger funds to find more profitable investments than smaller rivals and take big stakes in companies. The larger funds also have to ignore fast-growing smaller companies just because there isn't enough stock available to make an impact on the portfolio.
Fidelity has had problems unwinding large positions. Consider Micron. On Sept. 30, 1995, Fidelity owned 19.6 million shares of the semiconductor maker, of which Vinik held 11.8 million. But when he soured on Micron in October--along with many other investors--it took him at least two months to unload his stake. As he sold, Micron lost nearly all of its 1995 gains--helping to deflate Magellan. After peaking at a 42% year-to-date gain in mid-September, the fund slid to 36.8% by yearend, just below the S&P 500's return.
A small fund is more nimble than a large one. At Fidelity, the difference can be striking. Until Sept. 30, 1995, both Magellan and Fidelity New Millennium Fund, which had less than $500 million in assets, had close to 40% in technology. They were also neck and neck in performance, with Magellan up 38.9% and New Millennium up 40.9%. Then came the technology rout. New Millennium owned networking and communications stocks that largely sidestepped the decline. Vinik owned them, too, and a whole lot more, amounting to $20 billion. Magellan took four months to sell its tech stocks. The result: New Millennium logged a 52.14% return for 1995, while Magellan's return slid.
MANAGEABLE SIZES. One internal rule can also hobble performance, say sources close to Fidelity. Fidelity has long had self-imposed limits on how much the firm's funds could collectively own in a company. The complex now limits itself to buying no more than 13% of the publicly available stock in any company, though the limit can go to 15% with special permission. One former fund manager says he was barred from buying several stocks at bargain prices because of the 15% rule. "You get blocked out of your top picks, so you end up buying your second- and third-best ideas," says the source.
Fidelity executives deny that the rule is a hindrance. "It's rare for me to have any complaints about the 15% limit," says Stansky. Of his top 50 holdings, he says he's free to buy more of each. Still, the number of stocks that managers can be blocked out of is getting larger. In 1993, Fidelity owned 13% or more of 45 companies. Last year, that jumped to 86, reports Technimetrics Inc., which tracks institutional holdings.
A number of Fidelity's critics think the company should consider alternatives to unabated growth. Among the options: closing large funds to new investors or institutional accounts; cloning new funds, such as a "Magellan II"; moving more aggressively to a multiple-manager approach, as it has already done with three large funds; or opening funds specifically for 401(k) customers.
Many of Fidelity's smaller rivals have long since taken such steps. Putnam Investments Chairman Lawrence J. Lasser has abandoned a system of "star" fund managers in favor of a team approach to minimize the risk that any one manager will produce poor results. He has kept fund assets focused on a tightly defined set of risk parameters to appeal to retirement investors.
He has also kept funds to what he considers a manageable size. "When a fund gets so large that it disadvantages shareholders, we start a new fund," Lasser says. After its largest fund, the Putnam Fund for Growth & Income, reached $9 billion in assets in December, 1994, Putnam launched Fund for Growth & Income II, which now has $877 million in assets. Coincidence or not, Putnam's diversified U.S. funds did the best of any of the large fund families in the past one-, three-, and five-year periods.
Other mutual-fund giants are finding other options. Vanguard Group has closed some funds to new investors and added multiple managers in others. The $14 billion Vanguard/Windsor closed out new investors in 1985, when it hit $3.4 billion. Its successor, Vanguard/Windsor II, has had multiple managers since its 1986 launch. Last year, Vanguard closed the $2 billion Vanguard/Primecap Fund, which invests in small- and midcap stocks, after it pulled in $300 million in the first two months of 1995.
Clearly, there are advantages to size, and no one has been better at exploiting them than Fidelity. It has unparalleled access to corporate executives, who flock to its headquarters at a rate of 30 a day. As Wall Street's largest generator of commissions, Fidelity gets access to virtually any investment research it wants, and it receives favorable treatment on stock trades and initial public offerings.
No one is worried that Fidelity's performance will collapse as a result of its growth or its efforts to attract retirement investors. The concerns, rather, are that instead of being the best, Fidelity will be only second-best. Peter Lynch is certainly right when he says that what ultimately matters is the stocks in a portfolio. Fidelity can still blow away the competition if its funds invest well. Only now, it's a much harder task.By Geoffrey Smith in Boston, with Jeffrey M. Laderman in New YorkReturn to top