Has Success Spoiled Mutual Fund Giant? Fidelity Struggles To Overcome Problems Created By Its Huge Size
No modern investment firm has ever dominated the U.S. stock market the way mutual fund giant Fidelity Investments does today.
With about $548 billion of the public’s money and 9.7 million clients, Fidelity easily outstrips every other U.S. financial giant, such as Merrill Lynch & Co., J.P. Morgan & Co., American Express Co. or Prudential Insurance Co. Analysts say it is the largest investment management company in the world.
From its offices in downtown Boston, Fidelity controls nearly one-fourth of all the stock held by U.S. mutual funds, according to industry analysts, and that percentage is growing. On some days, it accounts for 10 percent to 15 percent of the volume on the New York Stock Exchange.
Fidelity, which has 227 stock and bond funds, is so big it has its own internal stock market where the investment managers trade among themselves. There is even an independent investment research service - Alpha Equity Research Inc., of Portsmouth, N.H. - that does nothing but provide professional investors with intelligence on Fidelity’s likely purchases and sales in the months ahead.
“You will not find another institution that bulks so large in the markets as Fidelity,” financial historian and retired Goldman Sachs & Co. investment banker Barrie A. Wigmore said.
But a six-month investigation by The Washington Post shows that Fidelity’s size is the source of some of its greatest problems. According to confidential company documents, mutual fund analysts, current and former executives, Fidelity is such a big player in the market that:
Its trading can distort the stock market. When Fidelity is buying or selling, it can drive prices of even the biggest stocks up or down sharply - hurting other investors and, sometimes, its own customers. “Don’t get in the way of Fido,” said Michael Harkins, a partner at the New York investment firm Levy, Harkins & Co., using Wall Street’s nickname for the mutual fund giant.
Its funds, swollen by cash, are losing their performance edge as portfolio managers struggle to put the money to work profitably. Studies done for The Washington Post by two mutual fund research and rating services, Morningstar Inc. and Lipper Analytical Services Inc., show that in the past two years fewer of Fidelity’s major U.S. stock funds are beating their own benchmarks or the funds of their biggest competitors.
Its management practices, intended to steer the huge flotilla of funds, may hurt the interests of Fidelity investors. For example, Fidelity funds often share some of the same stocks, so investors may not get the diversification they expect. And Fidelity’s internal rules sometimes block funds from investing in profitable companies.
The Securities & Exchange Commission has begun an examination of Fidelity to learn more about how its funds exercise their influence. The SEC examination was launched shortly after The Washington Post published confidential Fidelity trading data on Dec. 1 showing that Jeffrey N. Vinik, the 36-year-old manager of the $53 billion Magellan fund, had been talking up semiconductor maker Micron Technology Inc. when he was quietly selling most of his stake in the company.
The SEC also is looking at unusual end-of-month runups in the value of Magellan and some of the stocks in which Vinik’s fund has been a large investor. Other investors have filed lawsuits in Federal District Court in Boston accusing Vinik and Fidelity of stock manipulation.
Fidelity said Vinik was not available to discuss these matters, and the firm’s chief counsel, Robert Pozen, denied any wrongdoing. He said he saw no contradiction between Vinik’s favorable statements about Micron and the contemporaneous selling.
Internal Fidelity memos reviewed by The Post suggest that officials are aware of the problems posed by its enormous size.
According to a confidential memo distributed in the early 1990s to some senior executives and investment managers, the size of the funds was tops among “sensitive investment issues” for the firm. The memo instructed senior executives and portfolio managers to emphasize with outsiders that size need not be a disadvantage to investment performance.
Publicly, Fidelity executives maintain that size is not a significant challenge for their stock funds.
“If you look at the bad effects of size, you can’t neglect the good effects,” said George Vanderheiden, the head of Fidelity’s growth stock fund group and a longtime fund manager. “It is much easier for us to get information from companies than it was 15 years ago.”
But mutual fund research companies Lipper and Morningstar note some slippage in Fidelity’s stock market performance.
Morningstar, which looked at how well Fidelity’s major U.S. stock funds have done since the last stock market correction of 1990, found a recent deterioration. In the two-year period from December 1991 to December 1993, more than 80 percent of these funds outperformed the stock indexes Fidelity uses to gauge their performance.
But in the more recent two-year period from December 1993 to December 1995, fewer than 15 percent of Fidelity’s major U.S. stock funds beat the indexes.
Fidelity performance also appears to be slipping relative to the next four largest fund families, according to Lipper.
Three and five years ago, about half of Fidelity’s stock funds ranked among the industry’s top performers. In 1995, about one-fourth of Fidelity’s stock funds ranked among the industry’s top performing stock funds.
Fidelity executives said they are pleased with their funds’ overall performance. Vanderheiden said Fidelity funds still beat two-thirds of their peers.
Analysts and former Fidelity fund managers said Fidelity’s weakening performance results from the burden of too much money to invest. For example, they said, a large fund is less able than a small one to trade in and out of stocks in response to significant market news.
They note that in 1980 Fidelity managed only $10 billion, or about 2 percent of the money it manages today. Since 1985, the average Fidelity stock fund has grown from slightly less than $1 billion to slightly more than $6 billion, according to Morningstar. It is not unusual for a large Fidelity stock fund to receive $10 million a day in new money from investors.
“Fidelity’s investment performance has only been so-so in the last several years,” said William Nutt, a Boston-based mutual fund consultant and former head of another investment firm, the Boston Co. “They are choking on money. That is the price of success.”
The tidal wave of cash can swamp the best investment ideas, said a recently departed Fidelity fund manager, who spoke on condition he not be identified.
“You find a great idea and then there is a race to buy it before the fund manager in the next office,” the former manager said. “You buy as much as you can, but the money is flowing in, $10 million to $20 million a week. … So you start buying your second-best and third-best ideas.”
Former Fidelity managers note that even talented managers such as Vinik are burdened by this problem. They said that while Vinik was precisely right last year in emphasizing technology stocks, he failed to beat the S&P 500 stock index.
“If he had been managing less money, Jeff would be up double the S&P,” said a former Fidelity manager who said he is a friend of Vinik. This manager said Vinik has so much cash to invest that he cannot restrict himself to his best high-tech stock picks.
“If he had been running less money, he would have played technology in a more high-grade way,” the source said.
“Ask Fidelity how many companies their managers are currently blocked out of,” the former fund manager suggested. “You are always trying to replace your best stock with some new name because you can’t buy any more of what you really like.”
A Fidelity spokesman declined to respond to the question. Generally, Fidelity’s limit is 10 percent of a company, but occasionally it will buy as much as 15 percent of large companies. As of September, Fidelity had hit the 10 percent level in 305 companies with a total market value of about $450 billion, according to CDA Spectrum Research Services. These companies included Chrysler Corp., Caterpillar Inc., CSX Corp., Deere & Co., RJR Nabisco Holdings Corp. and Black & Decker Corp.
To cope with the constant inflow of cash from customers, Fidelity has intensified its research effort to find good new investment ideas, officials said.
It also increasingly has been placing big bets on entire sectors of the market as much as picking individual stocks. Fidelity hopes for big returns if a sector does well.
“There is no doubt that Jeff (Vinik) and other managers have taken more of a thematic approach to investing and narrowed the scope of their individual stock selection,” said Eric Kobren, president of Fidelity Insight, a newsletter that tracks the mutual fund complex for investors.
When Vinik moved Magellan into technology, he did not buy five or 10 stocks, he bought scores. When he bought banks and brokerages and insurance companies, he bought dozens. When he sells, he unloads in size.
And when Magellan moves in and out of sectors, other Fidelity funds tend to do so as well.
So how does this financial elephant move through the jungle without tramping down all the trees? That problem - selling profitable positions without putting enormous downward pressure on those stocks - is a legitimate concern, according to William J. Hayes, Fidelity’s chief operating officer for stock investments.
“We have tried to minimize our market impact in several ways,” he said. For example, Fidelity’s 35-person trading group uses many outside brokers and one of its own brokerage units, National Financial Services Corp., to disguise the firm’s trading activities from others on Wall Street. “We think we have built trading systems to mitigate Fidelity’s market impact,” Hayes said.