Will Fidelity Magellan Take a Nine-Figure Pay Cut?

Fidelity Magellan's (FMAGX) expense ratio may be on the verge of declining. That's good news for shareholders, and not-so-good news for Fidelity.

Why the potential fee cut at Magellan? One word: performance. Many of Fidelity's retail funds, Magellan among them, sport performance-based adjustments to their expense ratios. Put simply, the better their returns versus a benchmark index over the trailing three years, the more Fidelity gets paid, up to 20 basis points (or 0.20%) over the base expense ratio. Similarly, if a fund's performance trails the index over that period, as many as 20 basis points could be lopped off the base expense ratio. Twenty basis points may not sound like much, but at a huge fund like Magellan, they add up to a hefty sum.

To understand Magellan's current situation, one must look back a few years. When the Asian economic crisis hit in 1998's third quarter, technology stocks got pummeled. Sensing a buying opportunity, many of Fidelity's diversified-fund managers, including Magellan's Bob Stansky, loaded up on the sector's shares. Among Stansky's picks were some huge winners such as AOL, which is now part of AOL Time Warner . Magellan delivered an exceptional gain in the ensuing months, returning 36.6% during the half year ended March 1999. Meanwhile, the S&P 500, which serves as the benchmark index for the fund, gained "just" 27.3%.

Thanks largely to that strong six-month period, the fund still boasts a trailing three-year return that beats the index's. But from April 1999 through August 17, 2001, the fund's returns have closely tracked the S&P 500's. Thus, unless Magellan posts much better returns than the index over the next few months, Fidelity is at risk of losing much or all of its positive performance fees. During the fund's last fiscal year, they amounted to 0.14% of assets, or a total of well over $100 million. That's big money even for Fidelity's large and well-diversified parent, FMR Corp., which has no doubt already been buffeted by a declining stock market and reduced growth in its brokerage business.

Of course, it's well worth pointing out that Stansky could still go on a tear. After all, he added a lot of value in just a few months in late 1998 and early 1999. He could do so again (or he could even fall well short of the index). And it's also true that Fidelity's finances are strong, and will almost certainly remain so, whether or not it loses Magellan's positive performance adjustment. FMR Corp. has thus far avoided the big, across-the-board layoffs enacted by competitors like Charles Schwab (SCH), and unlike crosstown rival Putnam Investments, it has not fired investment professionals. Finally, a number of Fidelity's smaller funds, including Dividend Growth (FDGFX), appear likely to continue earning positive performance adjustments. Losing Magellan's performance fees would be painful but wouldn't come close to crippling FMR Corp.

Whatever the potential short-term effects on FMR's earnings, we remain supportive of performance fees. It's true that these fees add volatility to management companies' bottom lines. That, along with the difficulty of consistently beating an index, is probably why most firms eschew performance adjustments. But as the Magellan example illustrates, they give the few companies that employ them a lot of incentive to produce strong longer-term returns. Performance-based fees don't guarantee a fund will beat its benchmark, but does anyone doubt that Fidelity has provided Stansky with a wealth of resources to do so? Moreover, most of Fidelity's funds with performance fees have beaten their peers over the long term. We don't know what the next few months hold for Magellan, but given Fidelity's incentive to improve returns and Stansky's strong overall managerial record, we wouldn't want to bet against the fund over the long haul.

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