Fidelity's Incremental Improvements Go a Long Way

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. 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).

It's impossible to paint Fidelity with a broad brush. It's long been an industry leader in technology, trading, and its brokerage platform, but has had ups and downs within its own mutual fund business. The dependable fixed-income division remains a crown jewel, though it's often overshadowed by the larger equity division, which for years was inconsistent but has shown signs of improvement. The ascension of Abby Johnson to the CEO role in October 2014, while anticipated and unlikely to cause a major shake-up, does bear watching. However, recent developments at Fidelity have been more modest than dramatic--subtle changes a casual observer might miss. Yet taken together, the firm's research division is moving in the right direction and has become more stable, earning Fidelity an upgrade in its Corporate Culture grade to B from C.

Steady Improvement
For years, change seemed to be the norm in Fidelity's equity division, both at the analyst and portfolio-manager level. Analysts wouldn't stay in a position for long, rotating between industries with the goal of becoming the next Will Danoff or Peter Lynch at a diversified growth fund. Those who did well were rewarded with new roles at bigger, higher-profile funds, leading to constant musical chairs among Fidelity's huge fund lineup. That began changing in the mid-2000s when Fidelity carved out a career analyst path for people who didn't necessarily want to run a diversified fund. Some analysts still rotate on the path to becoming portfolio managers, but the change has led to more stability at the sector analyst level. In 2004, there were no analysts with more than 10 years of industry experience. Today, that number is 39, reflecting a more experienced analyst team.

The pace of change has also slowed at the manager level. Average manager tenure across Fidelity's funds has modestly climbed over the past few years and is now 5.5 years. (It's 8.7 years on an asset-weighted basis, reflecting greater stability at Fidelity's biggest funds.) Fidelity still isn't an industry leader when it comes to manager tenure; the firm has been relatively quick to change managers at underperforming funds, which can be beneficial over the long term, but it suggests there have been problems getting the right people in the right seats. Even so, the firm's year-over-year improvement in manager tenure is encouraging.

Just as important, Fidelity has been more careful in how it has handled manager transitions. Abrupt manager changes were long the norm, which could be jarring for shareholders who suddenly owned a much different fund after a new manager came in with a new process. Modeling other industry-leading firms, Fidelity has started to announce some manager changes well in advance, allowing the incoming manager to work with the outgoing manager for a period of time before going solo. This process is currently happening at  Fidelity Advisor Growth Opportunities (FAGAX) and  Fidelity Small Cap Value (FCPVX), both funds where the incoming managers have no track record of their own and are likely benefiting from a longer transition with their experienced mentors. This process may result in fewer portfolio overhauls when the incoming manager goes solo, which could reduce tax implications for shareholders. The firm has also added comanagers at some prominent funds, such as  Fidelity Advisor New Insights (FNIAX), potentially hinting at succession plans for long-tenured star managers like Will Danoff.

However, Fidelity's equity fund lineup isn't perfect: 21 of the 52 equity funds that received Morningstar Analyst Ratings as of September were rated Neutral. (Across all Fidelity funds, 15% of assets were in Neutral-rated funds, 49% of assets were in Medalist funds, no funds received Negative ratings, and 36% of assets were in funds Morningstar didn't rate as of September.) Often, Neutral-rated funds are run by managers who are relatively new to their posts or who haven't yet proved their processes are effective. Fidelity could do a better job of establishing and defining repeatable investment processes across its sprawling equity fund lineup to help provide a more consistent shareholder experience when manager changes occur. Even so, aggregate performance across Fidelity's equity funds has improved. For the trailing decade through September 2014, the category median across all of Fidelity's equity funds was 37, and it was 30 for the trailing five-year period. Granted, the five-year period now excludes the tumultuous late 2007 to early 2009 bear market, when many of the firm's equity funds tanked. Managers are now better equipped with quantitative risk-management tools and have undergone deep dives to determine vulnerability in their investment processes. That's not to say Fidelity's equity funds will emerge from the next downturn unscathed, but there's arguably a bigger emphasis on risk management than in the past.

More Than Just a Growth Shop?
Fidelity has also made strides in diversifying its growth-centric equity lineup. In the past, Fidelity managers played to the firm's strengths, so nearly all of its equity funds were growth-oriented--even those supposedly focused on value or income. Under CIO Tom Hense's leadership over the past four years, the firm has built value and equity-income teams, making manager changes that in some cases were likely difficult. For instance, Larry Rakers of  Fidelity Dividend Growth (FDGKX) had a good record but didn't focus on dividends, so he was replaced in early 2014 with Ramona Persaud, who's taken a purer dividend-focused approach at her other charge, Fidelity Global Equity Income (FGILX). Other funds, such as  Fidelity Equity-Income (FEQIX), now have higher yield targets under new management than they did historically.

Meanwhile, the firm is trying to bolster its value franchise. It's unclear how much the value managers are able to use Fidelity's central analysts, who tend to remain growth-oriented, but it's encouraging that Fidelity has carved out a group of managers focused on these funds. Fidelity has had mixed success with team offshoots in the past, but some have prospered, such as the small-cap team, founded in 1999 by Joel Tillinghast of  Fidelity Low-Priced Stock (FLPSX). It's hoped the value team, which includes funds with very recent manager changes (Fidelity Blue Chip Value (FBCVX) in October 2014) and others with slightly longer manager tenures (multimanager fund  Fidelity Stock Selector Large Cap Value (FSLVX) in 2011), will have similar success in time. For now, several equity-income and value funds receive Neutral Analyst Ratings as most of these managers have been in place for less than three years and need to prove their strategies are effective. Investors can find plenty of more-established value funds outside Fidelity. Even so, investors who currently own these funds certainly benefit from the managers following their mandates more closely.

Fixed Income Remains on Solid Footing 
Fidelity is often thought of as an equity shop, but its fixed-income operation is a quiet giant that deserves much credit. It houses 19% of Fidelity's mutual fund assets (and more than a third when counting money market funds). Its investment-grade effort, based in Merrimack, NH, has avoided much of the turmoil that has plagued its equity counterpart. It's avoided disruption by embracing a team-based culture, fostering a collaborative environment where manager changes are handled gracefully. The team's proprietary risk-management tools are industry-leading and a vital part of the funds' careful investment process. Each team has its own quantitative analyst to help managers understand different types of risk in the portfolio. Risk oversight is viewed as an ongoing and shared effort across teams rather than a process monitored solely by CIO Christine Thompson, raising the bar for accountability across the group. Rather than relying on big interest-rate bets, the funds instead focus on getting broad sector allocations right and adding value through bottom-up research. Occasionally, some funds may look out of step relative to more aggressive peers, but the approach has reaped strong long-term risk-adjusted returns. The Boston-based high-yield effort also has its strengths, including a deep analyst bench, a relatively stable portfolio-management team, and several highly rated funds. Overall, all but one of Fidelity's fixed-income funds that receive Morningstar Analyst Ratings were Medalists as of September 2014.

Big Picture
It was encouraging, then, to see former fixed-income head Charlie Morrison named Fidelity's head of asset management following the early 2014 departure of Ron O'Hanley. Morrison, who started as a fixed-income analyst in 1987, is the first former portfolio manager to hold that position since Abby Johnson in the early 2000s. His predecessors haven't lasted long in the role--he's the eighth since 2001. Morrison previously worked with Abby Johnson, Fidelity's recently named CEO, in other roles at the company, and his strong pedigree and success in leading the fixed-income team is a plus.

Even so, challenges remain for Fidelity. Outflows at its diversified U.S. equity funds over the past year--even after accounting for inflows into its equity index funds--suggest investors haven't stuck with the firm even as it's made much-needed improvements. Of greater concern are the firm's missteps with its target-date funds. Fidelity helped pioneer target-date funds in the 1990s and had a tight grip on the industry's assets thanks to its record-keeping platform, but in recent years its Freedom Funds have lost considerable market share to better-performing competitors. In mid-2014, Fidelity's series of target-date mutual funds relinquished its top spot in terms of assets to Vanguard. The firm has tried to fix mediocre performance by tweaking the series' glide path, adding tactical allocation, and bolstering the team that supports the Freedom Funds, but it's too soon to deem those efforts a success: Morningstar currently rates Fidelity's target-date series Neutral.

In other ways, Fidelity has come out ahead. Its efforts to combat money market reform were largely successful after the SEC avoided a massive overhaul of retail money market funds. (Nancy Prior, who led that effort, has since been named Morrison's successor as head of fixed income.)

Meanwhile, the firm has taken a cautious approach to new fund launches, which is wise considering Fidelity's lineup is already so big. It's avoided jumping on the alternatives bandwagon (outside a failed attempt at a 130/30 fund a few years ago). Its biggest product initiative has come in the form of ETFs, where it's partnered with BlackRock on the passive side. In 2014, it launched three actively managed fixed-income ETFs based on existing mutual funds; the jury's out on the market's appetite for such investments. Like other fund companies, Fidelity has filed with the SEC for permission to launch nontransparent actively managed ETFs, which if approved could lead to new actively managed equity ETFs.

Some equity funds with big asset bases remain open, but Fidelity has gotten better about closing funds flush with inflows, particularly on the small-cap side. More broadly, Fidelity has added interesting analytical resources, such as hiring an ex-CIA agent who contributes geopolitical research that's particularly useful for the firm's emerging-markets debt team.

Overall, Fidelity's fund lineup remains reasonably priced, and investors seem poised to have better outcomes than just a few years ago following incremental improvements on the equity side. Its fixed-income funds are still among the industry's best. Taken together, Fidelity earns a Corporate Culture grade of B.

This article is the Corporate Culture portion of the Morningstar Stewardship Grade for Fidelity. Click here to see Morningstar's Stewardship Grade methodology.