Asset bloat – Fidelity Magellan fund reopens

Fidelity has just announced that their flagship Magellan fund, which has $45 billion of assets, will reopen to new investors. The fund, which once reached over $100 billion of assets, had been closed to new monies since 1997.

A cynic could ask why the fund is being reopened now. Fidelity state that inflows are needed to balance redemptions thus giving the manager the best opportunity to deliver good investment returns. But redemptions are not a recent phenomenon – poor investment performance cannot account for a 55% fall in assets.

Is it a coincidence that the fund is reopening after a period of excellent performance? The current manager outperformed the S & P 500 index, a broad measure of the US stockmarket, by over 13% in 2007, the best performance the fund has seen for many years.

I’m sure Fidelity will not have any problems enticing new investors into the Magellan Fund. Investors persistently select investments that have performed well recently, as they believe that this good performance will continue in the future. The same ‘logic’ drives investors to cash out after a period of poor performance and seek out another successful manager. I described this self-defeating phenomena in my article ‘The Human Brain – are we programmed for investment success?’

History and logical reasoning show that large fund inflows make a manager’s task exceptionally difficult, if not almost impossible.

When Peter Lynch took over the Fidelity Magellan fund in 1977 it had assets of $22 million. When he retired in 1990 the fund stood at $14 billion. This huge increase in assets occurred after 1983, when he became publicly known following his exceptional performance. Lynch became one of the first modern money managers to achieve ‘cult’ status.

However, with his new found fame and fund assets Lynch realised he could not follow his previous investment strategy. Initially he could buy small unknown companies that other managers and analysts had overlooked. As the fund grew he simply could not find enough of these stocks to buy, or he could not deal in the quantities he needed to. He was forced to invest in larger more liquid companies. Unfortunately this area of the market attracts considerably more coverage by analysts and managers and thus provides less chance to uncover ‘undervalued’ stocks. This competition from managers drives out the easy excess returns that can be available in more esoteric market segments. Peter Lynch’s overall record was outstanding over his 13 year tenure, but investors who bought in after 1983 did little better than the overall market. His incredible stockpicking ability had become overpowered by the shear weight of assets he was forced to invest. Peter Lynch retired as a fund manager in 1990, aged 46.

The Peter Lynch and Magellan fund story highlight a number of cold hard truths in the modern investment management world.

1. Managers can be more nimble and can take advantage of potentially lucrative opportunities, without impacting upon a share price, when they manage small amounts of money.



2. The combination of good recent performance and seductive marketing by fund management companies attracts massive cash inflows into successful funds, as investors chase good past performers.



3. Large cash inflows and large funds make a manager’s job increasingly problematic, as he struggles to make investments of enough size and scope for good returns. The larger a fund becomes the more it tends to replicate the overall market as a manager has to spread his investments, further diluting his previous successful style.

It will be interesting to review the Magellan fund performance over the coming years, but I can’t say that the signs are good.

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Impartial advice - you decide

Dear Christian,

What could turn an investment of £1,000,000 into £6,220,000 over 10 years, earning you initial and trail commissions over the term in excess of £123,000?

This was the start of an email I received last week from a fund management house. No mention of the features and benefits of the investment opportunity for a client, but a considerable focus on the rewards on offer for an adviser. Consider this in light of the words of Callum McCarthy, Chairman of the FSA, in a 2006 speech.

“…In the 18th century, we exported our criminals to Australia, and paid on the basis of every convict shipped aboard at the quayside at Bristol or London. On average, 12 per cent of those who were shipped aboard in Britain died en route; on some voyages more than one in three of those shipped died before reaching Australia. In 1792, the system was changed... Shippers were paid for every convict delivered alive in Australia, rather than shipped aboard in Britain. In 1793, three convict ships sailed to Australia transporting 422 convicts, of whom 421 were delivered alive – a mortality rate about 1/50th of what had previously occurred. The new reward structure produced immediate and dramatic change….quite simply, incentives matter. They change behaviour…”

Investment opportunities marketed with a focus on potential returns and adviser remuneration always fill me with scepticism. Ask yourself this question – why are they offering commission? Will a fund not offering commission be utilised even if it offers a better proposition? McCarthy goes on to state “Provider bias is clear: I am struck by the prevalence of examples of providers managing demand – up or down – by adjusting commissions which can lead to less suitable or even unsuitable sales.” There is no doubt that esoteric investments or unknown fund managers often offer increased commissions to attract greater sales. This particular fund was targeting Indian infrastructure projects – certainly not a mainstream sector.

If you value impartiality, you must consult a wealth manager who offers independent and fee-based services. Sadly these fundamental principles are harder to find than you would think, in what is still predominantly a sales driven industry.

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A new year, a new column, old lessons

The New Year is traditionally a time when investors review their performance over the previous year and look to amend their portfolios in the search for this year’s winners. The finance pages are awash with this year’s stock and fund tips from the great and the good of the marketing…sorry investment industry.

2007 will undoubtedly be remembered for the ‘credit crunch’ bought about by the collapse in the US sub-prime mortgage market. Hedge fund managers talked in terms of ‘six-sigma’ events happening, which statistically should happen only once every 796 years. Others thought the conditions even worse. Lehman Brothers head of quantitative equity strategies, Matthew Rothman said:

“Events that models only predicted would happen once in 10,000 years happened every day for three days."

Benign economic conditions and rising capital markets rarely expose the dangers inherent to many investors’ portfolios, but market turmoil tends to uncover weaknesses, sometimes with disastrous consequences. Even the ‘black-box’ mathematical models of the worlds best hedge fund managers cannot cope with the force of the markets when they move.

Undoubtedly one of the saddest episodes of the year was the fall from grace of Northern Rock and the impact on the tens of thousands of small shareholders. Northern Rock shares lost 92% of their value over the calendar year, compared to a fall of just 2.5% for the FTSE All-share index. I use the word ‘sad’ because the severe impact on small shareholders financial positions could largely have been avoided. Whilst I can sympathise, they only have themselves to blame because they ignored one of the cardinal rules of investment – diversification.

Diversification or ‘don’t put all your eggs in one basket’ in simple terms, was first scientifically studied by Harry Markowitz in 1952. His seminal work not only earned him a Nobel Prize but changed the way we build portfolios forever. Markowitz proved that a diversified portfolio is greater than the sum of its parts, and allows an investor to reduce their risk without reducing their expected return. The risk reduction comes from reducing the ‘stock selection’ risk – i.e. the specific risks attaching to one company. For example, Northern Rock’s business model had a structural weakness, which caused its virtual collapse when short-term corporate borrowing rates rose dramatically above central bank base rates. This is a stock specific factor. By investing in a ‘diversified’ portfolio of shares which react differently to varying economic conditions you can remove all stock specific risk and leave only the residual ‘market risk’. Market risk is ever-present and cannot be negated. The FTSE all-share fell by 2.5% in 2007 demonstrating the market risk of the UK stockmarket. So by investing in the broad market rather than in Northern Rocks shares, we can see that risk is dramatically reduced. But just as important is that the expected return from the diversified ‘market’ portfolio is hardly affected. How can this be? The expected return from medium to large companies such as Northern Rock is quite similar. Why should investors demand a higher return from a medium size bank than a medium sized retailer, with the same asset backing and growth prospects? There is no reason. So by selecting a portfolio of shares across sectors, both large and small and also from different countries you can diversify away all stock selection risk and country specific risk from your portfolio. Then by investing across asset classes, such as equities, bonds and property you can add further diversification.

Investors who ignore the power of diversification are missing out on the best ‘free lunch’ in the investment world, and for what? For nothing, they are gaining no higher expected return but they are exposing their portfolios to the chance of ‘bombshells’, such as the northern rock fiasco, blowing their future financial wellbeing to kingdom come.

To diversify private investors need to forget about owning individual shares, they just don’t have enough cash to make it cost effective or practical. Collective funds are invariably the best way to provide the highest level of diversification, whilst keeping charges and taxes to a bare minimum.

So my three tips for 2008:

1. Forget the stock tips you see in the personal finance press and leave share ownership to the hopeless dreamers, speculators and gazillioanaires.



2. Review your portfolio and ensure that you are benefiting from the power of diversification so you can see out the inevitable choppy waters that lie ahead in world capital markets.



3. Even diversification cannot prevent the ups and down of capital markets. Risky assets command a ‘risk premium’ and therefore a higher return because of their additional risk. This is an immutable truth. Don’t put your faith in investments which seemingly achieve the alchemy of modern finance - high returns with low risk. 2007 was a year which demonstrated once again that so-called ‘freak’ economic conditions happen far more often than the statistics would suggest. So only invest in what you understand and in investments which have a fundamental reason for the return that they offer.

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