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Fidelity Working to Up Its Game

The firm has strong spots, but it needs more consistency.  

Katie Rushkewicz Reichart, CFA, 10/31/2013

Morningstar recently issued a new Stewardship Grade for Fidelity. The firm's overall grade--which considers corporate culture, fund board quality, fund manager incentives, fees, and regulatory history--is a B. What follows is Morningstar's analysis of the firm's corporate culture, for which Fidelity receives a C. This text, as well as analytical text on the other four Stewardship Grade criteria, is available to subscribers of Morningstar's software for advisors and institutions: Morningstar Principia®, Morningstar Advisor Workstation(SM), Morningstar Office(SM), and Morningstar Direct(SM).

Fidelity's impressive size has worked for and against it. As one of the fund industry's biggest companies with roughly $1.5 trillion in assets under management as of mid-2013, the privately held firm has never had a problem pouring resources into areas that benefit the end investor. The scale of its research, compliance, and trading operations are hard to match. However, its size hasn't translated into industry-leading offerings across the board.  

Playing Catch Up
The firm has recently invested heavily in endeavors where it has ceded significant market share to competitors. For instance, in 2013, Fidelity launched Select Co., a Denver-based entity that houses its nascent exchange-traded fund efforts and existing lineup of sector-based "Select" mutual funds, hiring Tony Rochte from State Street and Greg Friedman from iShares and Russell.

While many argue Fidelity was late to the party, the firm has gone about its foray into the ETF market smartly. It partnered with BlackRock BLK (parent of ETF leader iShares) instead of building a passive outfit from the ground up, and in time, Fidelity will look to leverage its long history of sector-based research through actively managed ETFs and custom solutions. (So far Fidelity has only filed for a few actively managed fixed-income funds.) That Select Co. is based outside of Fidelity's Boston headquarters (and has a separate board of directors) could mean the firm thinks this venture needs space to develop its own culture; how that will affect staffing long term, including the mostly Boston-based Select managers (who also feed research to the diversified portfolio managers), remains to be seen.

Elsewhere, the firm has invested heavily in areas where its once-formidable competitive advantages have eroded. A pioneer of target-date funds in the 1990s, Fidelity Freedom Funds long had a stronghold on that market's assets, thanks to the firm's dominance in the 401(k) record-keeping business. However, Fidelity lost significant market share (it dipped from 62.1% in 2005 to 32.4% by the end of 2012) as the funds' performance languished, more innovative competitors sprang up, and investor appetite turned more toward index-based fare. In response, Fidelity shored up its global asset-allocation group, which grew from 36 people in 2011 to 67 by 2013, including hires from the IMF and Barra. As part of the group's reorganization, Bruce Herring was named CIO, leaving his post as equity CIO, where he made inroads in improving risk management and portfolio construction following the equity funds' generally dismal performance during the 2007-09 financial crisis.

With more manpower, the team refueled its research, using revised capital-market assumptions and participant data to justify upping the Freedom Funds' equity exposure to levels similar to Fidelity's biggest competitors, T. Rowe Price TROWand Vanguard. The team also addressed criticism about the bland underlying funds featured in the series by adding investments run by star managers Will Danoff of Fidelity Contrafund FCNTX and Joel Tillinghast of Fidelity Low-Priced Stock FLPSX. While Fidelity could have improved its middling series sooner, it's encouraging that the firm has taken action.

Pockets of Strength and Weakness
Other parts of the company have long been more stable and successful. Fidelity's fixed-income team, which ran about 21% of the firm's mutual fund assets (excluding money markets) as of September 2013, is among the best in the industry. With operations based in Merrimack, N.H., the taxable investment-grade and municipal-bond groups have developed their own tight-knit culture. Managers and analysts work collaboratively, supported by Fidelity's significant investment in proprietary tools, and share a risk-conscious approach. Meanwhile, the high-yield group, based in Boston, boasts an extensive analyst staff and supports a number of well-respected funds. The overall team has enjoyed stability in its ranks, save for the occasional departure, such as Fidelity Floating Rate High Income's FFRHX Christine McConnell, who retired in March 2013 after 26 years at the firm. Thanks to a team-oriented approach, succession planning at individual funds has largely gone seamlessly. Long-term performance has been strong, too: For the 10-year period through September, the median category rank for Fidelity's fixed-income funds was 24. As of September, all but one fund with Morningstar Analyst Ratings were medalists (the lone exception was rated Neutral).

Fidelity hasn't been as consistent on the equity side: Of the 60 equity funds rated by Morningstar analysts as of September, 43% were Neutral.

The problem is not a lack of resources. The global equity analyst team numbers around 140 and published an average of 103 research notes per day in 2012. Long notorious for shifting analysts around different sectors and industries on their way to managing diversified funds, Fidelity has curbed that trend by embracing the career analyst track and trying to maintain some consistency in management at its major sector funds (the industry-focused funds still see significant turnover). Today, about a quarter of its ranks are on the career analyst track, which has boosted analyst tenure. The firm now has 34 analysts with more than 10 years of industry experience; in 2004 that number was zero.

Fidelity's international operations aren't quite as developed as the domestic-equity side. The firm long used research from its affiliate, Fidelity Worldwide (formerly FIL), but started building up its own global analyst ranks a few years ago in anticipation of an organizational split that occurred between the two entities in 2013. Since 2007, Fidelity has hired a mix of experienced analysts and MBA graduates who take a more global view than Fidelity Worldwide's country- and region-focused analysts. While now official, the split may not have a huge effect on the international-fund portfolio managers, some of whom say they've been relying on the newer crop of analysts for a few years now. The true test will be in long-term performance: The firm's international-equity funds have been middling over the trailing five- and 10-year periods through September and still have much to prove. 

Maneuvering Through Change
Fidelity faces challenges within its sprawling lineup on the domestic-equity side, too. For one, the fund board and executive management's heavy emphasis on the three-year performance period means there is still a fair amount of manager turnover relative to other large competitors, as Fidelity is quicker to make changes at funds that have struggled. (Fidelity often finds other roles for displaced managers, though that doesn't lessen the disruption for the fund investor.) While turnover may be warranted in some cases, the problem is often in how it's carried out. For one, an incoming portfolio manager can have a drastically different approach than his predecessor. A classic example is Fidelity Magellan FMAGX, which since the legendary days of Peter Lynch, turned into a benchmark-hugger under Bob Stansky to a bold offering under Harry Lange and back to a staid fund under current manager Jeff Feingold.

What's more, a new portfolio manager is often thrust into a fund with an ill-defined process, left to his own devices to see if what he tries works. It can take a rough patch to figure out where his strengths and weaknesses are, which can lead to portfolio tweaks, such as making smaller bets on individual names or avoiding heavy exposure to sectors where he hasn't shown skillful stock-picking. In some cases, that may help, or the manager may be replaced again. However, the ramp-up period is jarring for shareholders, who can bear the brunt of a manager who wasn't suited for the job to begin with.

Other big shops have structures in place that promote strategy continuity, even in the face of a manager change. T. Rowe Price aims for long transition periods with the outgoing manager. American Funds' team-managed approach means departures aren't as jolting, and up-and-comers have a chance to get their feet wet by running a small slice of money. Wellington groups like-minded investors together to oversee particular strategies, such as deep value or quality growth.

Fidelity is taking small steps, adding comanagers to improve succession planning and help handle capacity at its biggest funds. Danoff, who runs more than $100 billion between Contrafund and Fidelity Advisor New Insights FNIAX, chose John Roth as his comanager at New Insights. Gopal Reddy assists Steve Wymer at Fidelity Advisor Growth Opportunities FAGOX (Wymer also runs the closed Fidelity Growth Company FDGRX). Tillinghast selected a team to run a small sleeve of Low-Priced Stock. Derek Janssen was named comanager of Fidelity Small Cap ValueFCPVX following huge asset growth at manager Chuck Myers' two charges (both funds are now closed to new investors).

Elsewhere, Fidelity has created multimanager funds run by different sector managers, a plan that can minimize the impact of departures but runs counter to Fidelity's heritage of trying to foster star managers. Meanwhile, Fidelity is trying to institutionalize some strategies. For instance, it tapped value-minded investors to oversee Fidelity Equity-Income FEQIX and Fidelity Growth & Income FGRIX, two funds that previously failed to live up to their names, and the firm is trying to revitalize its value team, long an afterthought at growth-leaning Fidelity.

Such experiments have a mixed history of success. The small-cap team, created in 1999 and now about 20 members strong, has thrived. It's had lower turnover than the broader equity team (though it hasn't been free of it; the managers at Fidelity Small Cap Stock FSLCX and Fidelity Small Cap Growth FCPGX changed in late 2011). The team has succeeded largely because of leader Tillinghast, a well-respected investor who has produced stellar results during his 24-year tenure at Low-Priced Stock. He was instrumental in its creation and in training managers who have gone on to have successful careers, such as Myers.

Other experiments, such as a separate growth team located in a different Boston-based building, have been scrapped. And the broader equity team isn't as cohesive as the small-cap team. That has contributed to the phenomenon of murkily defined strategies and concerns about transition planning across the fund lineup.

Furthermore, in the wake of Herring's move to the global asset allocation group earlier this year, two new equity CIOs were promoted to oversee areas in which they never were previously involved: Former international manager Melissa Reilly is heading up domestic-growth and capital-appreciation strategies, and Tim Cohen, previously a domestic-equity manager and high-income director of research, is overseeing the international funds. Fidelity says they were chosen to provide a fresh look. However, it's hard to know how much buy-in they have from the teams they're overseeing or how they'll improve Fidelity's equity lineup.

Big Picture
Elsewhere, Fidelity has plans to improve the formulaic shareholder letters that have been the status quo for years, which will perhaps better explain each manager's strategy. It does publish other useful research pieces on its website, such as sector and market outlooks.

Finally, while Fidelity has laid the groundwork for entering the ETF market, it has been much more cautious about launching other products that investors might not use well. It has partnered with Blackstone BX and Arden to offer alternative funds for customers on its managed-accounts platform, but it has no plans to roll out stand-alone alternatives funds available to all retail investors.

Fidelity has plenty of strong spots, and investors have flocked to them. Indeed, on an asset-weighted basis, manager tenures are longer, performance is better, and the percentage of Morningstar Medalist funds is higher than using straight averages. However, Fidelity is responsible for its entire lineup, and plenty of other areas are still works in progress. This balance of strengths and weaknesses keeps the firm's Corporate Culture Grade at industry standard, or C. 

This article is the corporate culture portion of the Morningstar Stewardship Grade for Fidelity. Click here to see Morningstar's Stewardship Grade for Funds methodology.

 

Katie Rushkewicz Reichart is a senior mutual fund analyst with Morningstar.

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