Is Fidelity Swamping the Mid-Cap Arena?

In the past, we've discussed at length Fidelity's failure to close in a timely manner its funds, particularly behemoths  Magellan (FMAGX),  Low-Priced Stock (FLPSX), and  Contrafund  (FCNTX) (which remains open). In addition, my colleagues and I have expressed increasing concern over the capacity of Fidelity's small-cap funds; Low-Priced Stock, which recently migrated to the mid-blend category from small-blend, still looms large there. When a firm owns a large chunk of a particular stock, that can create difficulties for the fund managers within that firm who own it--buying shares can drive up the stock's price, while selling it can have the opposite effect, thus making trades less profitable. Even managers of small funds are left with reduced flexibility when they own the same stocks as their colleagues' larger funds, as they attempt to stay out of the way.

We believe Fidelity could be headed for similar trouble in the mid-cap space. According to our calculations, Fidelity owns roughly $125 billion in domestic mid-cap stocks within its actively managed funds. And although inflows to its sprawling fund lineup have slowed quite a bit lately, its mid-cap stake is likely to rise. While investors have yanked money from struggling large-cap offerings such as Magellan, Fidelity's mid-cap funds have become some of the largest in their categories. Low-Priced Stock checks in at $38 billion (including more than $10 billion in domestic mid-caps), mid-value fund  Fidelity Value (FDVLX) has swelled to $15.6 billion in total assets, and mid-growth offerings  Fidelity Mid Cap Stock (FMCSX) and  Advisor Mid Cap (FMCAX) hold another $11 billion and $8 billion, respectively. And although Low-Priced Stock and Advisor Mid-Cap are closed, Fidelity rolled out a new offering,  Advisor Mid Cap II (FIIAX), less than two weeks after the latter fund was shuttered.

Fidelity's most successful large-cap funds also tend to have sizable stakes in smaller fare: Contrafund, for example, owns roughly $9 billion in domestic mid-caps within its $64 billion asset base. Furthermore, two of Fidelity's largest funds, Magellan and  Growth & Income (FGRIX), were recently taken over by Harry Lange and Tim Cohen, respectively; each was quite willing to dip down the market-cap ladder at his previous charge. Lange has boosted Magellan's stake in mid-caps, and we'd expect Cohen to do the same at his new charge.

It's worth noting that no other mutual fund family faces this particular issue on such a scale. Vanguard Group and American Funds have surpassed Fidelity in terms of combined equity and bond-fund assets. But a large portion of Vanguard's stock-fund assets are in low-turnover index funds, while much of the remainder is spread across a number of outside managers with diverse approaches, as well as their own analyst staffs and trading desks. American, for its part, doesn't offer any mid-cap funds, and its largest stock funds don't tend to hold significant mid-cap stakes; its domestic mid-cap holdings add up to approximately $54 billion, less than half of Fidelity's total. And the fourth-largest fund shop, Franklin, is much smaller than the other three.

A Bull in a China Shop
Fidelity's massive pool of mid-cap assets, combined with overlap across its funds and a limited number of analysts devoted to mid- and small-cap stocks, has led to sizable stakes in its mid-cap favorites. As of December 2005, we found 32 mid-cap stocks in which the firm recently held at least 10% of the outstanding shares; in 23 cases, it owned 10 or more days' worth of a stock's average trading volume. Since it's generally considered prudent for fund managers to avoid moving much more than a fifth of a stock's daily trading volume in a given day (to avoid greatly impacting a stock's price), that means it could potentially take Fidelity 50 business days--or ten weeks--to completely unload its position in any one of those 23 stocks. And the firm sometimes leaves an especially large footprint. For example, at the end of December 2005, Fidelity owned more than 25 days' worth of the trading volume in human-resources firm Robert Half International (RHI), and nearly 15% of its outstanding shares. Although that company recently had a market capitalization of $6.4 billion, it was recently held in a bevy of Fidelity funds, including mid-growth offerings Mid Cap Stock and  New Millenium  (FMILX), large-growth funds  Advisor Equity Growth  (FAEGX),  Blue Chip Growth (FBGRX), Contrafund and  Advisor Destiny I (FDTOX), and large-blend vehicles Magellan, and  Export & Multinational .

In other cases, the sheer girth of Fidelity's largest mid-cap funds alone can swamp a stock's shares. Audio-equipment maker Harman International , Advisor Mid Cap's largest holding, can also be found in Mid-Cap Stock's top 20. As a result, Fidelity recently owned 14% of the stock's outstanding shares, and 12 days of its trading volume. Thus, it might take three months to sell its stake in this volatile stock, which posted huge gains in 2003 and 2004, but lost 23% last year.

Fidelity's apparent liquidity issues are all the more significant because few of its managers employ a simple buy-and-hold approach; many like to trade around positions in an attempt to add value. While Low-Priced Stock's Joel Tillinghast and Value's Rich Fentin have long made only gradual moves in their portfolios, trading is an engrained practice at most of Fidelity's mid-growth funds: Both Mid-Cap Stock and Advisor Mid Cap have seen triple-digit portfolio turnover every year since their respective 1994 and 1996 inceptions, and Aggressive Growth has hit a similarly lofty level every year but one since its 1990 inception. Some of the portfolio turnover at these funds is a reflection of one of Fidelity's most unattractive traits: Several of its most-prominent mid-cap funds have suffered through a good deal of manager turnover. Mid-Cap Stock has seen five changes at the helm since inception, and Advisor Mid Cap is on its third skipper.

To be fair, it's possible this situation will change for the better. Fidelity's 2005 announcement that it will double the size of its equity-analyst staff--including a significant buildout of its small/mid-cap team--should eventually lead to the unearthing of more mid-cap ideas, which would theoretically reduce overlap. But when we met with Fidelity executives this past summer, they also made clear their intention to dramatically increase the shop's assets under management. That, taken together with Fidelity's history of letting funds stay open too long, means the firm will likely continue to hold big stakes in its mid-cap positions.

What To Do
Given these concerns, what should shareholders in Fidelity's mid-cap-heavy funds do? Only two of those funds boast both a proven skipper and a very manageable asset base: New Millenium, which has been managed by Neil Miller since its 1992 inception (and closed to new investors a decade ago); and Advisor Mid Cap II, a newer fund whose skipper has posted fine returns at similarly managed variable annuity funds. We think these two offerings are solid choices. We also think investors have reason enough to stick with other accomplished managers running substantial mid-cap assets, such as Low-Priced Stock's Tillinghast and Contrafund's Will Danoff, although their charges' gigantic asset bases will eventually cause performance to slow. But we can't pound the table for most of the firm's dedicated mid-cap offerings, including Mid-Cap Stock, Advisor Mid Cap, Value, and Aggressive Growth. None of them are poor holdings, but investors with access to Fidelity's FundsNetwork brokerage can find better alternatives on the no-transaction fee funds list. Those seeking a value offering should check out all-cap vehicles  Muhlenkamp Fund (MUHLX) and  Third Avenue Value (TAVFX), or get more-consistent mid-cap exposure from  Delafield Fund  . On the growth side,  Buffalo Mid Cap (BUFMX) and  Wasatch Heritage Growth  are attractive choices.