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Fidelity Loses Top Mutual-Fund Spot to Bogle's Indexing

John Bogle has preached the virtues of low-cost indexing since the 1970s to investors willing to pay higher fees for big-name money managers at firms such as Fidelity Investments.

His persistence, which earned him the nickname “Saint Jack,” paid off this year when Vanguard Group Inc. unseated Fidelity as the largest U.S. mutual-fund company by assets, a distinction the Boston firm had held for more than two decades.

A decade bookended by bear markets has sapped U.S. investors’ faith in the ability of money managers to protect them from losses, spurring a rush into cheaper index funds pioneered by Vanguard. Bogle, 81, founded the Valley Forge, Pennsylvania-based firm in 1975 on the idea that most professionals can’t beat the market, so it’s not worth paying them to try. Edward “Ned” Johnson, 80, took over Fidelity two years later and built the family business by betting on star stock pickers such as Peter Lynch.

“It’s the triumph of indexing over active management,” Daniel Wiener, editor of Independent Adviser for Vanguard Investors, a New York-based newsletter, said in an interview. Index funds mimic the makeup of the market benchmarks they are designed to track, while active managers pick securities based on research.

Photographer: Ken Cedeno/Bloomberg

John "Jack" Bogle Sr., founder of Vanguard Group. Close

John "Jack" Bogle Sr., founder of Vanguard Group.

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Photographer: Ken Cedeno/Bloomberg

John "Jack" Bogle Sr., founder of Vanguard Group.

Fidelity Magellan Fund, run by a prominent list of managers including Johnson, Lynch and Jeffrey Vinik, produced middle-of- the-pack returns in the past decade. Once the world’s largest mutual fund, Magellan is now one-fourth the size of the $87 billion Vanguard 500 Index Fund.

Attention to Costs

Vanguard has benefited as the stock market foundered, said Michael Miller, a managing director at the firm. The market in 2009 came through its first full decade of losses since the 1930s, and U.S. bond yields are near record lows this year.

“People pay more attention to costs when returns are less,” Miller said in a telephone interview.

The shift may be more than temporary, said Jack Ablin, chief investment officer at Chicago-based Harris Private Bank, which manages $55 billion.

“It is possible investing has changed for good,” he said. “People don’t want to rely on stock pickers who have not earned their keep,” and active managers will have to “demonstrate that they have an edge that is worth the management fee they charge.”

On a dollar-weighted basis, stock-index funds charge an average of 29 cents per $100, compared with 95 cents for active funds, data from Denver-based research firm Lipper show.

Power of Marketing

Some of Vanguard’s success can be attributed to the “miracle of marketing,” said James Lowell, editor the FidelityInvestor.com, a Needham, Massachusetts, newsletter. The firm has sold investors on the benefits of indexing even though the strategy has yielded lackluster performance, said Lowell, who helps oversee $1.2 billion, mostly in active funds.

In the 10 years ended Aug. 31, actively run domestic stock funds returned 0.9 percent a year compared with an annual loss of 2 percent for index funds, data from Chicago-based Morningstar Inc. show. Fidelity’s equity funds returned an average of 2.1 percent a year versus 1.2 percent for Vanguard’s, according to Lipper.

Investors took a net $301 billion out of actively run equity funds in the U.S. from the start of 2008 through August, Morningstar estimates, while stock-index funds attracted $113 billion. The global financial crisis sent the S&P 500 sliding 57 percent from its peak October 2007 to its 12-year low in March 2009.

Vanguard also benefited from the popularity of bond funds. From Jan. 1, 2008, through Aug. 31, 2010, the company’s fixed- income portfolios pulled in $134 billion while Fidelity’s attracted $33 billion.

Passing Fidelity

The shift into index funds helped Vanguard snatch the No. 1 ranking from Fidelity in March. Johnson’s firm has topped the list each year since 1988, when it overtook Merrill Lynch & Co.

Vanguard had $1.31 trillion in fund assets as of July 31, compared with $1.24 trillion for its main rival, according to the most recent data from the Investment Company Institute, a Washington-based trade group.

Vanguard’s climb may also have been aided by its unusual business model. The company is owned by its mutual funds, which are owned by their investors.

“The ownership blueprint holds costs down and keeps the folks at Vanguard thinking like their customers,” Nancy Koehn, a professor at the Harvard Business School in Boston, said in an e-mailed response to questions.

Lynch Legacy

Fidelity is privately held, with 49 percent owned by the Johnsons and the rest by employees. The firm, while also offering cheap index funds, has been known for stock selection since the days of Lynch, who gained 29 percent a year before stepping down in 1990. From 1993 to 2007, funds led by stock pickers lured almost four times as much money as those that track benchmark indexes, Morningstar data show.

As the largest U.S. manager of money-market funds, Fidelity was also hurt as investors abandoned the short-term vehicles when yields fell below 1 percent last year.

Fidelity oversaw $442 billion in money funds as of Aug. 31, compared with $165 billion at Vanguard, according to Crane Data LLC in Westborough, Massachusetts. Fidelity’s money-fund assets fell 13 percent in 12 months.

“Our focus has never been on being the largest company, but on providing the best products and services for our customers,” Vincent Loporchio, a Fidelity spokesman, said in a telephone interview.

Edward C. Johnson II, the late father of the current chairman, took over the original Fidelity Fund, which is still operating, in 1943. Three years later, Fidelity was created to act as an adviser to the fund.

Fidelity’s Evolution

Once mainly a mutual-fund company, Fidelity now is “one of the world’s largest providers of financial services,” Loporchio said. The firm has expanded into stock trading, retirement plans and institutional money management.

In 2009, Fidelity reported operating income of $2.52 billion on revenue of $11.5 billion. The firm doesn’t report net income based on generally accepted accounting principles. Vanguard doesn’t release financial results.

In May, Fidelity named Abigail Johnson and Ronald O’Hanley to top roles after splitting responsibility for running the company. Abigail is Ned Johnson’s daughter. O’Hanley previously headed money management at Bank of New York Mellon Corp.

Vanguard had been catching up with Fidelity for at least a decade, since the bursting of the technology stock bubble in 2000 led to market declines through 2002.

At the end of 1999, Fidelity had $857 billion in mutual funds, 59 percent more than Vanguard, ICI data show. The tally comprises stock, bond and money-market funds. Each is priced at the end of the trading day based on the value of its assets.

$440 Billion Infusion

The ICI numbers do not include exchange-traded funds, a variation of index funds whose prices change as they trade through the day like stocks. Vanguard had $113 billion in ETF assets at the end of August, according to Boston-based State Street Corp. Fidelity has largely ignored that business.

In the 10 years ended Dec. 31, Vanguard’s stock and bond funds attracted $440 billion, compared with $101 billion for Fidelity, Morningstar estimates. This year through August, Vanguard pulled in $49 billion while Fidelity had withdrawals of $2.8 billion, according to the research firm.

Fidelity isn’t the only manager of actively managed stock funds to suffer at the expense of indexers. Investors at American Funds, run by Los Angeles-based Capital Group Cos., took out $29 billion this year while Baltimore-based Legg Mason Inc. had redemptions of $2.6 billion, Morningstar data show.

Wellington Fund

Indexing doesn’t explain all of Vanguard’s success. About 49 percent of the firm’s assets are in actively run funds, Rebecca Katz, a Vanguard spokeswoman, said in a telephone interview.

Among the firm’s active offerings are the $48 billion Wellington Fund and the $18 billion Vanguard Health Care Fund, the best-performing U.S. mutual fund over the past 25 years, according to Morningstar. The fund averaged annual returns of 15 percent, compared with 9.7 percent for the S&P 500, Bloomberg data show.

Still, almost 80 percent of the money Vanguard’s stock and bond funds attracted this year went to indexing, Morningstar said.

Indexing drew Kent Grealish, a financial adviser in San Bruno, California, outside San Francisco, to Vanguard in 2004. Grealish said he spent most of his career as a believer in stock selection. Over time, “I changed my attitude about my ability and the ability of others to beat the market,” he said in a telephone interview.

Industry Critic

His clients now essentially match the market’s performance at a low cost, he said. Vanguard’s biggest index fund, the $113 billion Total Stock Market Index Fund, charges clients as little as 7 cents for every $100 they put in, according to the firm.

For decades, said Harvard’s Koehn, Bogle has been touting his company’s simple approach and criticizing the financial industry for its supposed excesses.

“The world has changed profoundly, and Vanguard is sitting right where the market has arrived,” Koehn said in a telephone interview.

Bogle, who ran Vanguard until 1996, has stayed in the public eye by publishing articles and books and making media appearances. Bogle didn’t return a call seeking comment.

Fidelity developed a reputation for innovative products, solid customer service and for bringing mutual funds to a wider audience, said Russel Kinnel, director of fund research for Morningstar.

Lynch ran Magellan from 1977 to 1990, when his yearly gains were almost twice the S&P 500’s 15 percent. His books “One Up on Wall Street” and “Beating the Street” became best-sellers.

Mediocre Returns

More recently, the firm’s stock performance has been “mediocre,” Kinnel said. Fidelity’s equity funds beat 57 percent of their peers in the decade ended Dec. 31, Morningstar data show.

Magellan lost an average of 3.7 percent annually in the 10 years ended Aug. 31, compared with a decline of 1.8 percent for the S&P 500, Bloomberg data show. The fund’s assets have fallen to $20 billion from a peak of about $110 billion in 2000.

Fidelity still has some of the industry’s best-known managers.

Joel Tillinghast, who runs the $28 billion Low-Priced Stock Fund, topped all but one diversified U.S. mutual fund, Robert Rodriguez’s FPA Capital, over the past 20 years with gains averaging 14 percent, Morningstar data show.

Broader Business

Fidelity’s bond performance has been strong, said John Bonnanzio, editor of Fidelity Insight, a newsletter based in Wellesley, Massachusetts. Even so, the company has struggled to compete for investor attention with Pacific Investment Management Co., he said in a telephone interview.

“Fidelity doesn’t have the marketing zing Pimco can bring with Bill Gross,” Bonnanzio said.

Pimco, based in Newport Beach, California, has brought in $54 billion this year, the most among fund companies, according to Morningstar. Gross, named in January as Morningstar’s fixed- income manager of the decade, runs the world’s largest bond fund, the $248 billion Pimco Total Return Fund.

Fidelity operates a so-called fund supermarket that lets investors choose from more than 5,000 funds, most of them run by competitors. Its 401(k) business, the nation’s largest, offers both Fidelity and non-Fidelity funds to its 11 million accounts. The firm owns a discount brokerage that sells stocks, bonds, exchange-traded funds and other financial products.

“They have been preparing for the day when their funds couldn’t outperform,” Bonnanzio said.

To contact the reporter on this story: Charles Stein in Boston at cstein4@bloomberg.net

To contact the editor responsible for this story: Christian Baumgaertel at cbaumgaertel at +1- cbaumgaertel@bloomberg.net

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