Fidelity’s Returns Policy

Fred Henning, head of fixed-income investing at Fidelity Investments, leans over a small table and points to a sheet of numbers.

“It takes a lot of work and discipline, but we think this is the way to go--and it’s working.”

He is referring to a new system--called targeted active management--of keeping bond fund returns fairly predictable for shareholders. That system now defines the nearly $200 billion of fixed-income money at Fidelity.

Henning, previously head of money market fund operations, took over all fixed-income investing after a series of mishaps derailed the stellar performances of Puritan and Asset Manager, two of Fidelity’s largest funds with significant bond holdings.

“Over a decade ago, we made a decision that we wanted to have bond funds that were aggressive, that would provide high returns,” Henning said. “What happened with this aggressive approach was that the funds were very volatile. Basically, we were guessing on interest rates.”

For example, if Fidelity thought that market interest rates were headed lower, it might load up its bond funds with longer-term issues, which would appreciate the most if rates indeed fell.

“What we’ve come to believe is that no one can guess interest rates,” Henning said. “All you do is add volatility to the funds. We also learned from a series of focus groups that very few people know about the inverse relationship of yields and bond prices. Our shareholders saw bond funds as something like enhanced savings accounts. They saw our money market funds as enhanced checking accounts. We also noticed that they were very good customers.

“So we decided to do what our customers wanted. Through internal policy we’ve eliminated non-investment-grade [bonds]. We’ve also changed fund names so the fund sounds like what it does. We really want to give the shareholders what they want: the investment results they signed up for and better results than most of our competitors.

“Those focus groups told us that people wanted predictability,” Henning said. “We don’t index, but we manage around a beacon, an index. What we match in the index is its duration [a technical measure of interest rate risk related to the average maturity of a portfolio of bonds]. We try to run interest-rate-neutral.”

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Note that this does not mean that interest rate risk--the potential for loss of principal if market interest rates rise, devaluing older, lower-yielding bonds--is eliminated. Basically, however, Fidelity fund buyers now will get the expected risk of an intermediate-term bond fund when they buy an intermediate-term bond fund, the expected risk of a short-term fund when they buy a short-term fund, etc., Henning said.

Getting away from making interest rate bets allows Fidelity managers to concentrate on skill events rather than chance events, he said.

“We can have a competitive advantage in security evaluation, opportunistic trading and credit analysis. When we do that, we’re playing to our strengths,” Henning said.

As proof, he showed the 12-month performance of Fidelity’s fixed-income funds, indicating that most had outperformed their “beacon,” and that an average performance advantage was 41 basis points (0.41 percentage point) above the beacon return.

“Our broad testing shows us that over a five-year period it is very difficult to beat the index, and that the index will be at the bottom of the first quartile” of total fund performance, Henning said.

What does that mean for future fixed-income performance at Fidelity?

Henning is reluctant to project.

But in his earlier job as manager of Fidelity money market funds, his goal was to have those funds perform in the top 20% of their peer group. Over the last five years, they’ve done just that or better.

A quick look at five-year performance data using Morningstar Principia fund research indicates that an additional 40 basis points a year over the performance of an index will put you in the top 15% to 20% of all funds in the category.

“This approach takes a lot more discipline. We had a significant turnover of people [when we put it in place]. When you run money this way, it takes the bet out of it. A lot of money managers don’t want to do that,” Henning acknowledged.

“In the old way, if a manager made a good interest rate bet, it overwhelmed the other areas of input. But now the funds are run by teams, and the teams have to work together. It takes a different kind of person.”

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But what will it do for long-term performance?

“If you beat the index, you’ll certainly be in the top two quartiles,” Henning said.

Could he make a tighter guess?

“I would expect us to be in the top of the second, bottom of the first quartile. It would surprise me if we weren’t in the top quartile. I think we’re on to something.”

Investor disappointment with fixed-income funds--usually because they have promised more return but delivered more risk--has contributed heavily to the net redemptions of government bond funds.

Don’t be surprised if the drumbeat of discipline and teamwork starts to ring through on the equity side of Fidelity as well.