Politics & Policy

The Off-Course Magellan Fund

Why pay active fees for worse-than-passive performance?

The flagship mutual fund of the Fidelity group has long been the Magellan fund. Peter Lynch guided it from 1977 to 1990, gaining enormous recognition as the lead portfolio manager at Fidelity by taking Magellan around the world and making his company wealthy in the process. At a 70 basis-point charge on a fund that once exceeded $110 billion in market value, Magellan produced an annual cash flow of $770 million for its owners at its peak. Even now, at $52 billion in market value, the fund produces an eye popping $364 million in annual revenues.

For Fidelity, however, the current payday isn’t good enough. The fund’s performance has been so “dismal” of late that Fidelity recently replaced its manager, Robert Stansky, who was a standout growth manager at the company before he came to Magellan some nine years ago. But the situation is much worse for shareholders seeking capital appreciation — the objective of the fund. Magellan has been, in effect, a closet index fund, even though it has claimed active management all along.

The data bear this out. For example, the risk factor (or the beta) of the Magellan fund is 1, exactly equal to the market risk as measured by the S&P 500. The R-squared of the fund is 0.99, almost the equivalent of the S&P’s. (According to Morningstar, R-squared reflects the percentage of a fund’s movements that can be explained by movements in its benchmark index. An R-squared of 100 indicates that all movements of a fund can be explained by movements in the index. Thus, index funds that invest only in S&P 500 stocks will have an R-squared very close to 100). Another measure of risk is standard deviation. Over the past ten years, the standard deviation of Magellan was 16.01 while the same statistic for the S&P 500 was 15.63, quite close for such a long time period.

Given the objective of the fund (again, capital appreciation) and the characteristics of the fund (a closet index to the S&P 500), one would expect to see at least some value-added relative to the S&P. However, the performance history of the fund is unusually dismal. The ten-year annualized return of the fund through Sept. 30, 2005, is 6.85 percent, or 2.63 percent per year worse than that of the S&P 500. In other words, an investor who chose to invest $10,000 in Magellan 10 years ago would have $19,389 today, while an investor who put that same amount in the Fidelity Spartan index fund would have $24,336. Magellan underperformed the S&P benchmark in five out of the past six years and was in the bottom half of its category for the same time frame. The more aggressive S&P (mid-cap) 400 index produced the equivalent of $37,505, or an annualized return of 14 percent during this ten-year period. One would have thought that a portfolio manager seeking capital appreciation would have ventured more into smaller stocks rather than hiding in the biggest cap stocks, the ones that all the institutional investors held.

Rather than being called Magellan, the fund should be called Smith, in honor of the captain of the Titanic.

Current shareholders of Magellan need to ask this question: “Does the Magellan portfolio manager try to add value?” One statistic that might reflect an active strategy that deserves the 70 basis point fee is the annual turnover of the fund. Unfortunately, the turnover statistic, which would show a fund manager making buy-and-sell decisions as a way of adding value, does not reveal active management. When I screened the Morningstar database for large blend funds, I discovered that the average turnover of those funds was 73 percent per year. At the other end of the spectrum, the Fidelity Spartan U.S. Equity Index fund had a turnover ratio of 5 percent. The Magellan fund? It had a turnover ratio of only 6 percent, hardly different from the Spartan fund and well below the average of the mid-blend large-cap equity fund.

Magellan’s new fund manager is Harry Lange, the “Robert Stansky” of ten years ago, who has been successful in running an aggressive but smaller fund, the $7 billion Capital Appreciation fund. In a recent interview, Lange said he views Magellan as “a very aggressive fund,” suggesting that he will be making major changes in the fund’s structure. Time will tell.

Indeed, Fidelity has made changes in fund management in the past that have not turned out to be in the best interest of shareholders. The problem is that Fidelity management makes the same mistake that the uneducated investor makes — it chases the winners. Back in the second quarter of 2000, at the height of the speculative growth bubble, Fidelity management canned the well-known George Vanderheiden, who managed the Fidelity Advisor Growth Opportunities fund after his bet on value stocks didn’t pay off. The new fund manager, Bettina Doulton, had an envious performance record at Fidelity prior to her new appointment. Early in her tenure she restructured the fund, exchanging value stocks for growth stocks just as the growth stock bubble began to burst. As a result, the fund’s five-year performance placed it in the 82nd percentile and its ten-year performance put it in the 96th percentile. For this, shareholders paid 1.15 percent per year in fees.

Fidelity’s full-page advertisements in the Wall Street Journal are now touting the low cost of its index funds, such as the Fidelity Spartan 500 which has an expense of 10 basis points. That’s a substantial discount from the 70 basis-point charge of Magellan, although both funds have similar portfolio characteristics. If Fidelity’s management makes the same mistakes going forward — in particular, if it keeps chasing the winners — and if large growth stocks make the comeback that market valuations imply they will, then shareholders in Magellan ought to sail over to the Spartan index and save 60 basis points in fees in the process.

– Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and principal of Victoria Capital Management, Inc.

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