Fidelity's stock and bond funds have reversed roles.
By Dan Lefkovitz | 12-26-07 | 06:00 AM | Email Article

It's time for me to get some new material. For years, I repeated the following line: Fidelity stock funds are struggling, while its bond fund lineup is shining. No longer. With days remaining in 2007, the performance picture at Fidelity funds is a mirror image of what we've seen in prior years.

Dan Lefkovitz is a content strategist for Morningstar's Indexes group.

First the good news. By my count, 60% of Fidelity's diversified equity funds are beating their category averages for the year to date through Dec. 21, 2007. (When I say "diversified equity funds," I'm including balanced funds, such as  Puritan  and the Asset Manager series, because people often use them in lieu of plain equity funds, and stocks mostly drive their relative rankings. And I'm excluding narrow industry and sector funds, such as Select Wireless   because their category rankings are often misleading. The raw numbers come out to 69 out of 114.) The number is up significantly from 2006, when just 48% beat their category averages. So far in 2007, a full 35% of Fidelity's diversified equity funds have landed in their category's top quartile.

What's even better news is that some of the shop's biggest funds are among the top-quartile finishers. That means lots of investors are benefiting. To name names in order of assets,  Contrafund  ($80 billion),  Magellan  ($45 billion),  Growth Company  ($37 billion),  Balanced  ($27 billion),  International Discovery  ($14 billion),  Disciplined Equity  ($11 billion),  Overseas  ($9 billion),  OTC  ($9 billion),  Fidelity Advisor New Insights  ($9 billion),  Fidelity Fund  ($8 billion),  Leveraged Company Stock  ($8 billion),  Independence  ($6 billion),  Fidelity Advisor Equity Growth  ($6 billion),  Small Cap Stock  ($5 billion), and  Europe  ($5 billion) are some of the big, prominent funds that have finished in their categories' top quartile this year. You'll notice that success is widespread. The list includes domestic and foreign funds from a wide range of categories.

Now the important part: the drivers of these awesome numbers. First, Fidelity funds have ridden a tidal wave of a year for growth stocks. Back in 2005 and 2006, I repeatedly argued that Fidelity's growth bias was holding it back. In those days, sectors such as financials and utilities were among the market leaders. In 2007, technology stocks have had a monster year, and tech is a Fidelity specialty. Credit Fidelity for nailing several of the year's biggest growth stories, including phenoms  Research in Motion ,  Apple ,  Google , and Nintendo, as well as health-care winners  Celgene   and  Elan . Fidelity has also won in some nontraditional growth areas, such as resources ( BHP Billiton ), industrials
( ABB ), and energy ( Schlumberger ). And Fidelity funds have generally sidestepped losses in the financial-services sector.

If you ask Fidelity, lots of credit for its 2007 outperformance goes to its research build-out. Recall that the global research staff has doubled over the past few years, with experienced analysts constituting many of the new hires. There's evidence to support this argument. By my count, 83% of its Select sector and industry funds, which are run by research analysts, are ahead of their benchmark indexes for the year through Dec. 21, 2007 (35 out of 42). The big caveat is we'll need more evidence than just a year to separate skill from noise.

Still, I'm thrilled for my fellow Fidelity investors about the 2007 showing. And I see the recent research build-out as Fidelity at its best. Driven by a hunger to be number one, it has plowed tons of cash into investment resources.

Now to the surprisingly poor 2007 recorded by Fidelity's bond funds. I'll start with the driver because it's really pretty simple: subprime. Fidelity's fixed-income operation didn't go whole hog into the alphabet soup of instruments backed by dubious mortgages, but it made some clear mistakes in gauging housing-market risk. Several funds had enough exposure to impact performance. When a bond's price goes from $1 to $0.30, that's going to hurt, even if plummeting securities represent just 5% of a portfolio's assets.

The overall bond fund numbers aren't dire at all. Three quarters of Fidelity bond funds were beating their category averages for the year to date through Dec. 21, 2007 (33 out of 44). Fifty four percent are top quartile in their peer groups. But most of the top performers are municipal-bond funds. Disturbingly, eight funds land in their peer groups' bottom quartile. Big taxable-bond funds like  Short-Term Bond  and  Ultra-Short Bond ,  Intermediate Bond , and  Investment Grade Bond  are stinking it up. In 2006, only three Fidelity bond funds finished in their peer groups' bottom quartile. In 2005, none did.

My colleagues and I have had several long conversations with Fidelity about bond fund performance this year. I've been left with mixed feelings. I'm obviously disappointed that with all the sophisticated fixed-income analysis Fidelity conducts and all the rocket scientists it employees, this could have happened--especially to a fund like Ultra-Short Bond, which I know some investors use as a cash substitute. On the other hand, I've been impressed with Fidelity's response. While they acknowledge mistakes, they also insist that the market has overreacted and that some healthy babies have been thrown out with the bathwater.

The funds that are down could come back. There's a narrow dispersion of returns in many bond fund categories. And as 2007 has shown us, performance numbers are a very fickle thing.

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Dan Lefkovitz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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