Fidelity Rides a Hot Streak Into New Year

The Vanguard Group is famed for its nautical imagery, but it was mutual funds archrival Fidelity Investments that patched a leaky ship last year.

Fidelity in 1998 logged some of its best performance results since the early 1990s, with several of its biggest and most visible stock funds beating the blue-chip Standard & Poor’s 500 index.

The flagship, $83.6-billion Magellan fund, for example, zoomed 33.6% last year, beating the S&P;’s 28.6% total return.

Also topping the S&P; were Fidelity’s Contrafund, up 31.5%; Blue Chip Growth, up 34.8%; and Dividend Growth, up 35.9%.

Moreover, the hot streak for many of Fidelity’s big winners last year has continued into 1999. Six of the firm’s 15 largest actively managed funds beat the S&P; last year, and five of those same six funds also are beating the index this year, through last week.

For 40% of a firm’s largest funds to beat the index is a high batting average, given that just 16% of U.S. stock funds overall topped the S&P; last year.

“I’d have to classify [1998] as an outstanding year for us,” said Robert Pozen, president of Fidelity’s money-management arm.

Others might argue that it is still too early for Fidelity’s 12 million shareholders to uncork the champagne and drain the bottle.

Despite the good results for many of its flagship portfolios, more than two-thirds of the company’s stock funds overall failed to beat the market in 1998.

But Fidelity seems to be moving in the right direction. Last year’s good showing helps allay concerns about wayward portfolio managers, defecting managers, funds that might have grown too large and other issues that have plagued the nation’s largest mutual-fund complex.

“Fidelity has dramatically improved its stock fund returns relative to other fund companies over the past two years, while bond funds have remained consistently good,” noted the independent Fidelity Insight newsletter in Wellesley Hills, Mass.

In 1996, by contrast, just two of Fidelity’s biggest funds beat the S&P; 500. Magellan lagged the index that year by 11 percentage points.

What explains the improvement? “Fidelity did well in 1998 because it got back to its knitting of picking stocks,” said David O’Leary, president of Alpha Equity Research, an institutional research firm in Portsmouth, N.H.

He said Fidelity’s results dimmed starting in 1995 when prominent managers such as George Vanderheiden and Jeff Vinik, who was then at the helm of Magellan, reduced their stock exposure out of fear that the bull market was nearing an end.

“It was a failed experiment in market timing,” said O’Leary, a former Fidelity employee.

Last year, many of Fidelity’s biggest funds stayed nearly fully invested--and reduced their cash holdings even further by year-end, as the market rallied. And the stocks they favored included some of the market’s hottest tech names.

Indeed, many of the funds listed Microsoft, Intel and America Online among their 10 largest holdings at year-end.

Apart from that stock-picking, outside observers give Pozen credit for Fidelity’s turnaround, saying he has kept managers more closely tied to their funds’ stated investment styles and has slowed the number of high-profile managers departing for greener pastures.

Pozen also restructured Fidelity’s compensation system in a way that allows for larger bonuses for managers who beat the competition. That has helped to retain top talent.

It has been two years since the manager of a broadly diversified stock fund has left the company, he said.

Among several other factors that contributed to the improvement, Pozen cites better internal performance tracking, more executive-level support for portfolio managers and a division of the research staff into areas of large and small-stock concentration.

S&P; Index Funds: Wide Gap in Returns

The performance gap between the best and worst S&P; 500 index mutual funds widened to 2.5 percentage points in 1998 from less than 1.5 points in the previous two years, according to researcher Lipper Inc. in New York.

That’s not supposed to happen. In theory, two S&P; 500 index funds should be as similar as, say, two pounds of sugar or two copper rods. They’re supposed to buy virtually the same stocks, in the same proportion, and closely track the index return.

But in reality, “S&P; 500 funds are not necessarily commodity products,” notes Kevin McDevitt, analyst at fund research firm Morningstar Inc. of Chicago. Even index fund managers, he said, “can add or subtract value.”

The main factor that affects relative returns in the index arena, however, isn’t management but the expenses that each fund charges.

The most penny-pinching firms such as Vanguard, USAA and Bankers Trust charge shareholders less than 0.25% of assets each year for fund management, overhead, record keeping, marketing and other standard outlays.

It’s no surprise that funds offered by these firms routinely place among the top third of index performers, although even they typically trail the S&P; 500 index itself, because any expenses come at the expense of shareholder returns versus the index.

But contrast the low-expense index funds with, say, the Morgan Stanley Dean Witter S&P; 500 fund. Its B shares carry an expense ratio of 1.36%.

Coincidentally, the fund finished near the bottom of the S&P; 500 index group for 1998, with a gain of 26.8%--noticeably below the 28.6% return of the index, and below the 28.1% average return of all index funds.

Although 2 or 3 percentage points a year may not sound like much, it can add up when compounded over time.

For example, in the 10 years ended Dec. 31, the Vanguard Index Trust 500 gained 471.5%, while the Stagecoach Equity Index A portfolio gained 422%--or 50 percentage points less.

Much of that gulf would be attributable to Stagecoach’s higher expense ratio of about 0.9%, compared with the Vanguard fund’s 0.2%.

McDevitt suggests avoiding index funds with an expense ratio higher than 0.5%. Preferably, investors should stick with funds whose ratios are below 0.25%, he said.

Yet total index fund costs include more than just the numbers that show up in a fund’s expense ratio. Trading commissions and stock bid-asked spreads also can erode a fund’s performance relative to competitors and a target index.

What’s more, there’s “tracking error”--if the index manager doesn’t keep the portfolio balanced precisely according to the moves of the stock in the index.

Tracking error helps to explain why a few S&P; 500 funds beat the index itself from time to time, and why some significantly lag it.

That may have been the reason why the GE Institutional S&P; Index fund last year gained 29.2%, or 0.6 percentage point better than the index itself, according to Lipper Inc. The fund had just $25 million in assets at year-end.

Small, new S&P; 500 funds are most likely to have a large tracking error. It takes at least $50 million for the typical portfolio to buy all 500 stocks in the index, according to Gus Sauter, manager of Vanguard’s Index 500 fund.

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Fidelity’s Big Names

While just 16% of U.S. stock funds beat the return of the Standard & Poor’s 500 index in 1998, six of Fidelity Investments’ 15 largest actively managed funds, or 40%, beat the index. Details on Fidelity’s biggest non-index funds, including 1998 returns and year-to-date returns through last week:

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Total return Fidelity fund Assets, in billions 1998 Year to date Magellan $83.6 +33.6% +1.7% Growth & Income 48.6 +28.3 -1.0 Contrafund 38.8 +31.5 +2.2 Advisor Gro. Opp. T 26.1 +24.0 -2.8 Puritan 25.7 +16.6 -0.5 Equity Income 23.7 +12.5 -1.7 Blue Chip Growth 19.9 +34.8 +1.3 Equity Income II 19.5 +23.0 -0.4 Asset Manager 12.9 +16.1 -0.1 Growth Co. 11.4 +27.2 +1.9 Fidelity Fund 10.6 +31.0 +1.2 Dividend Growth 10.4 +35.9 +0.3 Low-Price 9.2 +0.5 -5.3 Destiny I 7.4 +25.6 -2.9 Advisor Eq. Growth T 5.6 +38.7 +3.2 S&P; 500 index +28.6 +0.8 Average general stock fund +14.6 -2.8

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Source: Lipper