An inside look at what motivates the Boston behemoth.
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By Christopher Davis | 06-24-09 | 06:00 AM | Email Article

Fidelity's culture is defined by paradox. It invests heavily in its investment capabilities, but it's also a marketing machine. It's a leviathan, yet it encourages individuality. It hires some of the best and brightest analysts and managers, but it too frequently shifts them from fund to fund, making it difficult for investors to benefit from their talents.

Christopher Davis is Director of Fund Analysis at Morningstar Canada.

Ultimately, Fidelity's greatest strength is its individualistic ethic. It's not a place where you'll find many cookie-cutter personalities. Instead of imposing rigid, one-size-fits-all constraints, Fidelity managers have latitude to implement their own investment strategies. And unlike many overly buttoned-down investment organizations, Fidelity tolerates offbeat, and even eccentric, personalities--so long as they put up the numbers. While more buttoned-down investment organizations might push conformity, Fidelity encourages creativity. It could well be that the reason that great investors like Peter Lynch, Will Danoff, and Joel Tillinghast emerged from Fidelity is because they had the freedom to think and invest differently.

Tending to the Weeds
Letting a thousand flowers bloom means that you'll probably have to tend some weeds, and this has sometimes has been the case at Fidelity. Poorly timed interest-rate bets and ill-conceived forays into Mexican debt badly hurt many bond funds in the mid-1990s, for instance. And by the mid-2000s, it had become clear that Fidelity's edge in equity research had diminished in the wake of Regulation FD, which barred public companies from selectively sharing information regarding future earnings. Prior to its passage, Fidelity used its heft to gain access to top executives, enabling it to obtain information on companies' upcoming earnings announcements--and subsequent stock-price moves--before everyone else.

When troubles arise, however, Fidelity's reaction is rarely timid. After its bond funds' mid-1990s debacle, it endowed its Merrimack, N.H.-based bond shop with tremendous human and technological resources, reshaping it, with few exceptions, into one of the best fixed-income operations in the fund world. And to remedy shortcomings in its stock research effort, Fidelity has spent lavishly to more than double its number of equity analysts to nearly 500 worldwide--far more than the competition. It broke with tradition by hiring experienced analysts and for the first time opened a career track for those who didn't want to become portfolio managers. It also grouped portfolio managers into small teams with a few dedicated analysts in hopes of counteracting the bureaucratic effects of a large centralized analyst pool.

Fidelity has made other strides in recent years. It has shown an increased willingness to close funds. Historically, it had been reluctant to do so, presumably because closing a hot-selling fund cuts off a handsome fee stream and can limit distribution, especially in retirement plans--Fidelity's big cash cow. That tendency sometimes has been detrimental, especially at once-huge  Fidelity Magellan , which had grown too large by the late 1990s. But in 2006, Fidelity finally acknowledged that size can affect performance, closing six funds. (Most have reopened, though only after shrinking dramatically in size.)

Bigger Isn't Always Better
Fidelity's culture has areas of strength, but some traits make us uneasy. It's no exaggeration to say that Fidelity was instrumental in the creation of the modern American mutual fund industry, where single advisors run dozens of different kinds of funds--a departure from the original one-fund, one-advisor, one-board concept. In 1946, the shop advised just one offering--the Fidelity Fund--and by time Ned Johnson took over in the 1970s, there were two dozen funds. Johnson's asset-gathering ambition led him to create an ever-expanding lineup designed to cater to investors' every need or, as is often the case, desire. Indeed, by the 1980s, Fidelity offered 100 funds, by the 1990s, 200, and today more than 300. Surely many of these offerings serve useful purposes. And others have been innovations that have helped investors. Fidelity was well ahead of the curve in the mid-1990s when it launched its Freedom funds, one-stop retirement solutions that automatically become more conservative with age. It also led the way in creating its annuitylike Income Replacement funds in 2007.

Catering to practically every niche may serve Fidelity's business interests well, but it hasn't always benefited investors. Fidelity's three dozen-plus Select funds are a case in point. Some focus on broad sectors, such as technology and energy, but most are more narrowly tailored, focusing on industries like airlines and home finance. Those funds' restrictive mandates often lead to feast-or-famine performance, attracting investors when returns are hot and frightening them away when they're not. Fidelity's sprawling lineup also can make for a bewildering experience for investors. Retail large-growth investors, for instance, must sift between 19 different funds. It's difficult to imagine that there are that many talented managers to go around, let alone that many flavors of large-growth investing.

The long leash that Fidelity gives its managers also has drawbacks. Letting its managers employ their own distinctive strategies often has created headaches for investors when a new and equally distinctive manager takes over and changes course. Even if the new manager is skilled, a revamped strategy and portfolio may mean that the fund no longer fills the portfolio role that investors envisioned. Relatively high manager turnover exacerbates that problem.

An Organization in Flux
Fidelity's effort to expand its analyst ranks hasn't been an unqualified success. Initially, the deluge of new analysts led to culture clashes and saddled portfolio managers with information overload. Those concerns have abated, though there are still challenges. Analysts must communicate their research to hundreds of different managers--a daunting task. To cope, analysts frequently give the most face time to managers of the biggest funds, as that's where they have the most impact. But this system puts managers--not to mention shareholders--of smaller funds at a disadvantage. Fidelity could do more to retain talent and follow though on its pledge to let portfolio managers serve longer tours of duty. Yes, Fidelity's 88% manager-retention rate in 2008 was an improvement over where it landed in 2006 and 2007, when it clocked in at 82% and 86%, respectively. But among the largest 25 fund families, it lands smack-dab in the middle of the pack. I'm also disappointed that manager turnover at Fidelity Select funds hasn't improved in recent years. At the end of March 2009, the average tenure of a Select manager was 1.7 years. Three years before, that number was 1.8 years.

I'm also concerned that some recent personnel departures could be indicative of a larger problem. Boston-based rival Putnam, in particular, has nabbed some key Fidelity people, such as Walter Donovan, a Fidelity veteran and the firm's head of equities, to be its CIO. Donovan led Fidelity's analyst expansion, a worthy but as yet incomplete project. Early 2009 also saw the sudden retirement of Dwight Churchill, another Fidelity veteran who resumed leadership of the shop's fixed-income operation in 2008 after the subprime-mortgage meltdown blew up  Fidelity Ultra-Short Bond  and wounded other portfolios in 2007. I was impressed by the strides that Churchill made to address the breakdown, but it's unclear whether his successor, a non-Fidelity veteran, will continue Churchill's work.

Practical Take-aways
You increase your prospects of success by tapping into the best attributes of Fidelity's culture (such as the firm's willingness to give talented managers great freedom) while attempting to sidestep some of its worst (constant manager changes and the accompanying changes in strategy). Fidelity's best managers aren't exactly a secret; I don't have any trouble recommending Will Danoff's  Contrafund , Harry Lange's Magellan, Joel Tillinghast's  Low-Priced Stock , Steve Wymer's  Growth Company , or Jason Weiner's  Growth Discovery . These offerings generally aren't the most nimble around, but their size means that their managers probably get plenty of attention from analysts. These managers are at or near the top of the Fidelity food chain, so it's less likely that they'll be dispatched to run another fund.

Within Fidelity, there's also a top-rate subculture in its New Hampshire-based fixed-income offerings.  Fidelity Short-Term Bond  and Ultra-Short Bond remain works in progress, but bond investors generally should do well investing in both taxable and municipal funds. On the flip side, I'd be more reluctant to invest in smaller funds like  Fidelity Trend  or  Fidelity Export & Multinational , which have promising managers but historically have had a fair amount of turnover. If you do want to take a flier on an up-and-coming manager, I'd consider holding the fund in a nontaxable account. If the managers leave, you can follow them without having to worry about the tax consequences of selling.

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