Fidelity Keeps Moving in the Right Direction

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 B. 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 Advisor Workstation(SM), Morningstar Office(SM), and Morningstar Direct(SM).

Since its 1946 founding, Fidelity has grown from a single mutual fund company into a massive financial-services organization that counts brokerage, retirement, and technology services among its lucrative business lines. With $1.2 trillion in mutual fund assets under management as of August 2015, it remains the industry's second biggest mutual fund company despite investors' recent retreat from active equity investing, for which it's most well known. Yet improvements on the equity side following many funds' rough performance during the 2007-09 market downturn have put investors in a better position than just a few years ago. Meanwhile, the firm's steady, respected fixed-income operation remains an industry leader. More important, the firm has remained on a steady path following executive management changes in 2014, including Abby Johnson's ascension to the CEO role and Fidelity veteran Charlie Morrison's promotion to head of asset management.

Fidelity has tremendous resources at its disposal, and its size and scale can be an advantage. As one of the biggest owners of many companies, its investment team has significant access to management teams. It hosts an average of 21 company visits per day at its offices, which aids in the fundamentally driven research process used across its fund lineup. Being privately owned also helps avoid the pressure of quarterly earnings releases and investors' demand for cost-cutting: Despite $66 billion in redemptions from its diversified-equity funds since 2008 through August 2015 and overall firmwide inflows that have lagged all but three of the 10 biggest mutual fund companies during that period, it hasn't cut jobs on the investment team and remains well-resourced in technology and risk-management systems. It helps that the firm's other business lines have been so profitable: According to its 2014 annual report, Fidelity reported record annual revenue and assets under administration, a figure that includes other funds and products the firm offers.

Fidelity's huge scale hasn't always been an advantage. An equity analyst hiring spree in the mid-2000s didn't work out so well, serving as a reminder that sheer size doesn't necessarily equate to high-quality research that portfolio managers can effectively use. Its massive lineup of hundreds of funds also leaves room for some mediocre performers: The firm's 10-year Morningstar Success Ratio through August 2015, or the percentage of funds that survive and outperform their category averages during that span, was 45%--among the lowest of the top 10 fund companies by assets.

On the whole, though, Fidelity has made notable progress in stabilizing its investment team, improving fund performance, and becoming more shareholder-friendly. Instead of aspiring to simply have the biggest equity analyst team, the firm started focusing more on experience, hiring some career sector analysts who preferred to stay put instead of taking the traditional analyst path of rotating across sectors with hopes of running a diversified fund. That tactic has boosted the seniority of the analyst team: Today, 39 of 134 global analysts have 10 or more years of experience versus zero a decade ago. That includes improving tenure for the overseas analysts, who are a relatively new bunch. (In 2007, Fidelity began building its own international analyst team in anticipation of a 2013 split with affiliate company Fidelity Worldwide, which had historically provided all international analytical resources.)

The pace of change has also slowed at the manager level. Average manager tenure across Fidelity's funds has modestly climbed during the past few years and is now 5.7 years. (It is 9.5 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 equity funds, often emphasizing three-year results. But manager tenure has ticked up following a string of decent performance: The median trailing five-year category rank through August for domestic-equity funds was 28, and international equity was 25. In a particularly challenging environment for actively managed equity funds, Fidelity has held up better than some competitors. For the five-year period through August, 39% of Fidelity's actively managed U.S. equity funds beat their benchmarks compared with the 27% industry average. Its actively managed international-equity funds fared much better, with more than 90% beating their benchmarks to the industry's 49%, which reflects favorably on the international-equity analyst build-out. It helped that the growth style of investing that many Fidelity managers follow had been heavily in favor during that period, a trend that could reverse and potentially lead to sluggish performance and more manager changes. Even so, the firm's year-over-year improvement in manager tenure and equity fund performance is encouraging.

Fidelity has also become more thoughtful in how it has handled manager transitions. Rather than making abrupt changes, which often resulted in big portfolio and strategy changes, the firm has in some cases named a comanager who works alongside the lead manager before taking over the fund at a later date. This approach has played out well at

Leadership of the equity team has been fairly stable, too, with president Brian Hogan in his role since 2009. His tenure has included a renewed effort on risk management, which has been beneficial: Compared with 2008, Fidelity's equity funds on the whole performed better versus category peers in the rocky markets of 2011 and 2015's first eight months. Granted, those market declines were much less severe than 2008, but the improving trend is notable.

It has helped that Fidelity has diversified its growth-centric equity lineup. Historically, many equity funds played to Fidelity's strengths and had a growth-leaning bias, even ones with nongrowth mandates, which resulted in many of them performing similarly throughout a market cycle. Under the leadership of CIO Tom Hense during the past five years, the firm has boosted its value and income-oriented efforts, putting different managers in place who have adhered more closely to the fund's stated mandate. For instance,

Fidelity is often thought of as an equity shop, but its fixed-income operation shouldn't be overlooked. It houses around 20% of Fidelity's mutual fund assets (and closer to 40% when counting money market funds). Its investment-grade effort, based in Merrimack, New Hampshire, has been relatively stable through the years compared with its equity counterpart. It has avoided disruption by embracing a team-based culture and by fostering a collaborative environment where manager changes are handled gracefully. That's meant that even surprising departures, such as that of manager Pramod Atluri in 2015, aren't devastating to a fund.

Even a change at the top hasn't dramatically altered the division's path. Nancy Prior, who formerly headed the money markets group, succeeded Charlie Morrison as head of fixed income in 2014 when he was named head of asset management. Since then, the team's careful investment process has remained intact, backed by proprietary risk-management tools that are industry-leading. 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. Despite some turnover on the analyst team, it benefits from a stable and experienced portfolio-management team and features several highly rated funds. Overall, all but one of Fidelity's fixed-income funds that receive Morningstar Analyst Ratings were Morningstar Medalists as of August 2015.

There has been room for complacency in some areas. Fidelity's longtime stronghold on the target-date market eroded as more competitors entered the industry and its Freedom Funds turned in mediocre performance; in 2014, it dropped to the industry's number-two player in terms of market share, falling behind Vanguard. Fidelity made changes to its glide path, bolstered its asset-allocation team, and hired comanager Brett Sumsion to initiate active allocation. Morningstar currently rates Fidelity's Freedom Funds as Neutral since these changes are relatively new. The Fidelity Freedom Index series is rated Silver, though, offering a competitive choice for passive investors.

As might be expected from a fund family with hundreds of funds, Fidelity has taken a measured approach in terms of fund launches. Its biggest product initiative has come in the form of exchange-traded funds, where it's partnered with BlackRock to offer passive options. It also launched three actively managed bond ETFs in 2014. Fidelity's Denver-based SelectCo division, created in 2012, oversees its ETF operations and is focused on sector-based investing and creating ETF solutions for financial intermediaries and retail customers. So far, the ETFs have gathered around $3 billion, a far cry from the industry's giants but enough to land the firm in 22nd place in terms of ETF market share.

Fidelity has made moves toward becoming more shareholder-friendly. Although some equity funds with big asset bases remain open, Fidelity has gotten better about closing funds flush with inflows, particularly on the small-cap side. Shareholder communications have improved in recent years, too, changing from boilerplate annual reviews to more useful quarterly updates and manager Q&As that better reflect a fund's strategy.

Meanwhile, Fidelity spearheaded efforts to create Luminex, a new trading platform backed by nine large asset managers where institutional investors can trade large blocks of shares with each other without outside parties seeing (broker/dealers and high-frequency trading firms aren't eligible for inclusion). The goal is to limit stock price movements during big trades, which could reduce market impact costs and benefit the end investor. The trading platform is intended to run break-even, with profits reinvested in the business to help lower trading costs.

Overall, Fidelity is moving in the right direction. Its huge size has made consistent success across the organization difficult, but steady improvements on the equity side, more focus on its Freedom Funds lineup, and the continued strength of its fixed-income operation earn the fund family a Corporate Culture grade of B.

This article is the Corporate Culture portion of the Morningstar Stewardship Grade for funds for this fund family. Visit our corporate website to see Morningstar's Stewardship Grade methodology.