Fidelity's Experience Proves Bigger Doesn't Mean Better

If only the strength of Fidelity's investment culture matched its size.

It's not for lack of effort that the Boston-based behemoth hasn't become the best. No doubt, Fidelity usually has confronted challenges with gusto. It did so in the mid-2000s, for example, after it had become clear that the firm's edge in equity research had diminished. The early 2000s' passage of Regulation FD, which barred public companies from selectively sharing data that could materially affect stock prices, meant it could no longer rely on its access to top executives to obtain information on companies before everyone else. Fidelity spent lavishly in an attempt to retain a research edge, more than doubling its number of equity analysts to nearly 400 worldwide. By the numbers, at least, its analyst army became bigger than just about any competitor.

Fidelity also introduced significant organizational changes, breaking with tradition by hiring experienced analysts and, for the first time, opening a career track for those who didn't want to become portfolio managers. It grouped portfolio managers and analysts into small teams, helping counteract the bureaucratic effects of a large centralized research pool. And it pledged to give its portfolio managers longer tours of duty--a big change of pace for a firm that rightly had been known for high manager turnover.

Bold measures like these had borne fruit before. After poorly timed interest-rate bets and ill-conceived forays into Mexican debt badly hurt many bond funds in the mid-1990s, Fidelity endowed its Merrimack, N.H.-based bond shop with tremendous human and technological resources, creating one of the best fixed-income operations in the business.

The equity-research push has been less successful. Only now, after more than five years since beginning its analyst-hiring binge, is there is hope that its promised benefits have begun to materialize. Early on, the effort was beset by culture clashes, and with a deluge of new faces, portfolio managers didn't know who to trust. With time, the managers became better acquainted with the analysts' investment styles and capabilities. However, challenges remain. Analysts still must communicate their research to literally hundreds of different managers--a daunting task. To cope, analysts frequently give the most face time to managers of the biggest funds because that's where they have the most impact. But this system puts managers--not to mention shareholders--of smaller funds at a disadvantage.

Finding Portfolio Managers--and Keeping Them in Place
Much to its credit, Fidelity has stemmed manager turnover in recent years. Many of its sector-focused Select funds, which had been notorious for their managerial musical chairs, now benefit from experienced, skilled skippers who have been at the helm for a while, at least by Fidelity standards. But measured against the biggest fund families, Fidelity still falls woefully short in this area. Its average manager tenure, at 3.2 years, ranks 24th out of the 25 largest firms.

Such short stints contribute to one of the most maddening aspects of investing at Fidelity: Changes in management frequently lead to sweeping changes in funds' strategies, leaving shareholders with something different from what they signed up for. In 2008, for instance, Fidelity replaced manager Larry Rakers with a group of sector specialists at  Fidelity Balanced (FBALX), giving its once-eclectic, all-cap stock portfolio a relatively bland, S&P 500-like complexion in the process.

While average tenure speaks to the length Fidelity keeps managers at its funds, it doesn't say anything about its ability to retain talent. Unfortunately, the firm has hardly excelled in the latter regard, either. In the past five years, its annualized average manager-retention rate clocked in at 85%, placing 19th among the 25 largest fund families. It's true that few managers have left for greener pastures and most are dismissed for performance reasons. There's nothing wrong with dismissing perpetual laggards, of course, but that so many portfolio managers have been subpar to begin with calls into question Fidelity's ability to either hire the right people or develop them when they arrive.

The problem may not be identifying capable people as much as finding enough of them to fill its expansive lineup of funds. Fidelity has 17 large-growth funds geared toward retail investors, for example. It's difficult to imagine a single shop running that many industry-leading large-growth funds, in part because it needs at least 17 top-rate investors to run them. No wonder Fidelity managers as a group don't stand out.

A Look at the Executive Ranks
Fidelity's executive suites also have been in flux in recent years. Aside from the 80-year old Fidelity patriarch, Edward Johnson III, who has been chairman and CEO since 1977, nearly all of its top leaders took their posts in 2009 or 2010. That group includes the new president of asset management, Ronald O'Hanley, new management and research CIO Joe DeSantis, head of fixed income Christopher Sullivan, equity lead Brian Hogan, and international equity chief Bruce Herring. Some turnover, of course, is natural; O'Hanley and Sullivan both came aboard after their predecessors, both Fidelity veterans, retired. However, Hogan took his spot only after Walter Donovan jumped ship to Putnam to become its CIO in early 2009. And Herring took over from Eric Wetlaufer, who left after many prominent foreign funds turned in relatively weak numbers.

Even if the spate of departures doesn't signify a larger concern, new leadership introduces more uncertainty surrounding Fidelity's future than would be the case under stabler management. That's especially true in this instance because many of the new faces are Fidelity outsiders. While Hogan and Herring are longtime Fidelity hands, O'Hanley came to the firm after heading up BNY Mellon's asset-management division, DeSantis joined after a five-year stint as CIO of Evergreen Investments, and Sullivan was brought aboard after leading fixed-income funds at Goldman Sachs.

This leadership helms an investment organization that's evolved markedly from the halcyon days of the 1980s and 1990s, when Fidelity was known for swashbuckling stock-pickers like Peter Lynch, the famed former manager of  Fidelity Magellan (FMAGX). As a whole, the firm has adopted increasingly buttoned-down approaches in recent years. Fidelity's multimanager, sector-neutral strategies, adopted at funds like Fidelity Balanced and  Fidelity Stock Selector All Cap (FDSSX), are cases in point. To be sure, there are benefits to this shift: Performance may become more predictable, and because multimanager funds are led by several sector specialists, one departure won't lead to a wholesale portfolio makeover, as has often been the case at single-manager funds. But those advantages could come at the expense of Fidelity's traditionally individualistic, entrepreneurial culture. Its most successful investors, including Lynch, Will Danoff, and Joel Tillinghast, have been successful, at least in part, because they've had the latitude to think and invest unconventionally. Fidelity's newer generation of managers may not have as much room to roam.

As is the case at all money managers, Fidelity's top brass must balance the firm's business interests with those of fund shareholders. This tension isn't anything new for chairman Johnson, a tremendous capitalist whose drive to bring assets in the door led him to create an ever-expanding lineup designed to cater to every investor's need or desire. Under Johnson's leadership, Fidelity grew from two dozen funds in the 1970s to more than 100 in the 1980s, 200 in the 1990s, and more than 300 today.

Of course, many of these offerings served useful purposes, and others, such as Fidelity's pioneering launch of target-date funds in the 1990s, have been beneficial innovations. Others, though, haven't been so helpful. Fidelity's three dozen-plus Select funds are a case in point. Some focus on broad sectors, such as energy and technology, but most are more narrowly tailored, focusing on industries such as airlines, agriculture, and consumer finance. These funds' restrictive mandates frequently lead to feast-or-famine performance, attracting investors when performance is hot and frightening them away when it's not. Fidelity's sprawling lineup also can make for a bewildering experience, as investors who must sift among the firm's many large-growth funds would likely attest.

Playing It Safe?
Fidelity's success depends on far more than mutual funds, though. In the past decade, once-peripheral businesses, such as retirement-plan record-keeping, have played an increasingly important role. Indeed, Abigail Johnson, daughter of the chairman and his possible heir, described Fidelity as an "information-processing company" in a February 2010 address before the National Investment Company Service Association. This remark may reflect her role as head of the firm's distribution arm, but it's nonetheless difficult to imagine top brass from rivals like Vanguard or T. Rowe Price, who also have similar lines of business, describing themselves as anything but investment managers first and foremost.

That's not to say Fidelity can't still deliver superior investment results, but doing so while keeping its fingers dipped in many other pots won't be easy. There's also the risk that Fidelity's noninvestment business interests might encourage it to play it safe. It's unlikely, for instance, to be fired from running a defined-contribution plan as long as its funds deliver decent to good results. Neither are awful fates, to be sure, but they would hardly characterize a top-rate culture. Fidelity's move toward more index-conscious strategies may be one example where it could be playing not to lose--a change of pace from the highly competitive ethos that has long dominated Fidelity's culture.

Communication That's Far from Top-Notch
Finally, Fidelity also could do a better job communicating with shareholders. To be sure, Fidelity deserves credit for improving its disclosure markedly in recent years--for example, by voluntarily publishing monthly holding reports for its funds in 2007. However, while its shareholder letters aren't worse than some other large shops', they're nonetheless formulaic and rarely provide much insight into its managers' personalities and investment styles. More-detailed shareholder letters would help investors understand their strategies and perhaps make better use of them in their portfolios. Chairman Johnson's letters to shareholders have often demonstrated notably little effort to comment on fund performance, the future of his firm, or investing in general.

Conclusion
There's no denying the tremendous resources Fidelity devotes to its research effort, nor its ability to attract talent. But those advantages haven't translated into a superior investment culture. Despite its potential strengths, Fidelity's culture doesn't stand out.