Peter Lynch and the Fidelity Magellan Fund Case
1. Synopsis.
The case on Peter Lynch and the Fidelity Magellan Fund discusses the growth of mutual
funds and the increase in popularity of mutual funds as an investment tool. According to
the case, funds into mutual funds grew from $37.4 billion to $210.1 billion during the
period of 1981 to 1987.
An overview was presented on the mutual fund industry and its benefits to investors. The
case pointed out that mutual fund managers relied on some variation of either technical
or fundamental analysis. Moreover, the performance of mutual funds was evaluated by two
popular measures, which were the percentage annual growth rate of net asset value and the
absolute dollar value today of an investment made some time in the past. Lastly, a
summary of the Fidelity Magellan Fund and its performance was shown for the ten years
previous to 1987.
Issues of the Case.
There were a number of issues raised in the case. The first of which attempted to arrive
at an answer as to why mutual funds were becoming so attractive to investors.
The reasons given were that mutual funds allow an investor to instantly diversify. And
in theory, mutual fund managers have the expertise to give investors abnormally high
returns. But as the case argues, only one third of all equity, mutual funds provided
returns greater than the S&P 500, and that was before fees and expenses which range from
0.5% to 2.0% and 2.0%, respectively.
So the next issue raised was if traditionally used methods of evaluation were accurate
indicators of performance. Academicians criticized the frequently used measures of
percentage annual growth rate of net asset value and absolute dollar value today of an
investment made at some point in the past because these two approaches failed to adjust
for the riskiness of a mutual fund. After adjustments were made for the riskiness of a
fund, mutual funds were reported as being able to perform up to the market on gross
returns, but was underperforming, as compared to the market, after the various expenses
were factored in. Many analysts suggested that the average 1.3% expense ratio of mutual
funds and the need for the retainment of cash as the culprits of such underperformance.
Analysts desire to know how Peter Lynch, over the long run, consistently outperformed the
market since the use of traditional methods of analysis such as technical and fundamental
analysis could not guarantee above normal returns consistently over time. As some
experts suggest, it is merely luck that superstar portfolio managers, such as Peter
Lynch, achieve returns that are superior to the market over a long term basis. And
lastly, some suggest that Magellan, under Lynch, tended to outperform the market in bull
markets and underperformed the market in bear markets; this was attributable to Lynch's
strategy to be fully invested at all times, rather than attempting to time the extent of
market investments.
2. Information about Fidelity Magellan Fund.
* What is the Fidelity Magellan Fund? Is it a major player in the US equity markets? Who
are the major players?
The Fidelity Magellan Fund is in the family of Fidelity Investments that was founded in
1963. The ticker symbol is FMAGX and minimum investment in this fund is $2500. The
Fidelity Magellan Fund is presently managed by Robert Stansky and its assets total $54
billion, which makes it the biggest mutual fund and the latest average annual return is
14.9%. This is the fund that earned returns that consistently beat the S & P 500 while
under the management of Peter Lynch in the 80(s). It was for quite some time the
industry's standard bearer for excellence. Since 1981, Fidelity Magellan has earned a
total return of 1,302% for its shareholders, which is equivalent to turning $10,000 in
1981 to just over $140,000 today. But present day Fidelity Magellan has had trouble
beating the market as many feel it has gotten too big.
Fidelity Magellan remains a major player in the US equity markets. It continues to be
the largest mutual fund ($54 billion in assets and 14.9% return). Under Robert Stansky,
Fidelity Magellan in December 1996 reduced its bond holdings while raising cash. The new
bond position of the fund is now 3.8%, down from 7.9%. The fund's cash allocation
continues to rise; 3.6% increase in November and 6.6% increase in December.
Stansky feels Magellan with holdings in large-cap growth stocks will help it to rekindle
the stellar performance of the 80(s). In addition, Stansky's favorite sectors are the
energy and technology sector; Magellan's exposure has increased in energy by 14.5% and
Technology by 13.7%. Equity holdings edged up for the month of January to 89.6%. It is
important to note that although Fidelity Magellan remains a major player, experts feel
its sheer enormity will make it difficult for Stansky to achieve the stellar returns of
the Peter Lynch days and many cry for the dismantling of Fidelity Magellan into smaller,
more manageable funds.
The other major players in the US equity markets ranked by size are the following:
Investments of America ($30.9 billion, 13.3% return), Vanguard Index 500 ( $30.3 billion,
15.1% return), Washington Mutual Investors ($25.4 billion, 16.0% return) and Fidelity
Growth and Income ($23.9 billion, 17.2% return).
The following are other major players that delivered superior risk adjusted total returns
over the past five years: AARP Growth and Income (15.9% return), Babson Value (18.6%)
return, Berwyn Income (14.2% return), and Dodge & Cox Balanced (14.0% return).
3.What is Peter Lynch's investment style, and how well has Magellan done with it for the
period 1977-87 ?
Peter Lynch managed the Fidelity Magellan Fund from May 31 1977 till May 31 1990. During
this period the fund experienced its highest return: 2703.12% cumulative return versus
573.98% return of S&P 500. Its average annual return was 29.23%, compared to 15.81% for
the S&P 500.
There are a number of factors that contribute to Lynch's success. Being at Fidelity
Investments, he had vast amounts of information; in addition, he was able to digest this
information rapidly and assess it accurately. He met each investment opportunity with an
open mind, and he bought all types of stocks as long as they appeared to have good
potential for moving upward. Perhaps most important, Lynch displayed great zest for what
he was doing. He sometimes visited companies personally and logs thousands of miles
yearly, and to many of these firms, he had become a filter for new ideas they are
considering.
Peter Lynch is a straight fundamentals man. Following a fundamental approach, Lynch looks
for stocks priced below the company's value. But unlike others, he trades frequently as
the stocks move out of a narrow price range.He believes in staying fully invested at all
times, rather than attempting to time the extent of the market investment.
As a result, the Fund performed extremely well with bullish markets, and very poorly
during bearish markets (see Appendix 1). Lynch also attributes some lost return to
diseconomies of scale; he believes that if funds become too large, they are increasingly
hard and complex to manage, and certain inefficiencies might follow.
In recent years, after Peter Lynch left Fidelity Magellan, the fund has done worse under
the management of Jeff Vinik, as you can see from Appendix 2. The graph shows that it has
been underperforming the market, and the Morningstar's evaluation gives some insight on
the current situation and direction of the company. This lower performance has been
attributed to the larger size of the firm, and to the fact that Vinik did not fully
capitalize on the current bullish market.
If we look back at Appendix 1 we will see that for the period ranging from 1977-1987
Fidelity Magellan Fund outperformed the market for the most part except in 1981 when
Magellan fell down to 16.45% total return as opposed to 21.53 for the average portfolio
benchmark. Fidelity reached its peak in 1980 when it performed 32.22% over the S&P 500
(37.69%).
4. Performance of equity mutual funds.
When evaluating the performance of an equity mutual fund, many factors are taken into
account. Several commonly used measures are: yields vs. total return, load vs. no-load,
expense ratios vs. 12(b)-1 charges, one-year performance vs. ten-year performance, growth
vs. value and the composite performance measures.
In broad terms, past performance, expense ratios and performance against benchmarks are
useful to measure. Although good past performance does not ensure a profitable future, a
long history of good performance is a better indicator than a shorter one.
In terms of expenses, all else being equal, a fund that takes out less would seem to have
an advantage over funds that take out more. That goes both for annual management fees and
other charges, and for the sales commissions that are taken out at the front end.
On the qualitative side, there is management. You want to be sure that the manager
responsible for that stellar performance up to now is still there. There is also general
agreement that, all else being equal, its easier to generate above-average returns with
smaller funds that larger funds.
Last, but surely not least, there is risk. Investors want mutual funds that provide the
largest amount of return by taking the lowest possible risk. Modern Portfolio Theory
suggests that there is a direct link between risk and reward in the performance of any
given stock.
Risk can be a great ally when trying to estimate the reward potential of a stock
investment. The greater the stock volatility, or risk, the greater also is the reward.
There are several new risk measurements that give guidance for selecting mutual stocks
that provide higher returns for lower risk.
Composite portfolio performance measures have the flexibility of combining risk and
return performance into a single value. The most commonly used composite measures are:
Treynor, Sharpe and Jensen measures. While Treynor measures only the systematic risk
summarized by beta, Sharpe concentrates on total risk of the mutual fund.
The time horizon of an individual will also influence the performance measures he/she
will look at more closely. If you are investing for less than four years, you need a fund
with consistent performance, so all your money will be there when you need it. You also
do not have time to earn back a large commission charge on the front end.
Conversely, if you plan to invest your money for 30 years, neither consistency nor load
is very important: you have plenty of time for the market to recover. With a long-term
horizon, your biggest enemies are poor performance and high annual expenses, both of
which can erode that all-important compounding.
And if you are holding for four to ten years, you want a fund that offers a balance
between both extremes.
We mentioned before that in the period between 1977-1987 Fidelity Magellan outperformed
the market on average. This measurements, however, looked primarily at the returns,
without adjustments for risk. If we just look at the basic risk measurement of beta, we
will see that Fidelity Magellan is considered to be slightly riskier than the market
(beta=1.12).
We can nevertheless also take into account Treynor's and Sharpe's measures, which will
give us a better understanding of the relationship between risk and return for the
company. These measures still show that the company performed better than the market,
even after adjusting for risk. The consistency between the two measures shows that for
well-diversified portfolios, as this mutual fund is, the two measures provide similar
rankings (see Appendix 3).
The Jensen's intercept shown also in Appendix 3 merely shows that there was not much
correlation between the market and the company's return, which is consistent with the
fact that Magellan outperformed the market by far during that period.
The following graph is a more current evaluation of the same performance measures that we
just measured. As you can see, beta has decreased, thereby decreasing the risk, while the
company is still outperforming the market, if considering total return.
Performance measures (Recent)
Fidelity S&P 500 90-Day T-Bill Rate
Standard deviation 14.32 13.25 0.5
Average Annual rate of return 18.46 15.71 6.2
Beta 1.048 1
R^2 0.941 1
Treynor 11.699 9.508
Sharpe 0.856 0.717
Jensen 0.192 0
Appendix 4 shows a comparative listing of 20 selected mutual funds, and the performance
measures for each. This listing provides a more effective tool to compare the companies
with each other.
5. Explain why your client should invest in equity mutual funds instead of investing in
an individual stock
The main reason why an investor should avoid picking individual stocks is that a mutual
fund allows to have a diversified portfolio, thereby reducing your comparative risk and,
consequently increasing your comparative return. The amount of capital needed to obtain
this diversification is too large for the average individual investor.
Besides, mutual funds can achieve economies of scale in trading and transaction costs,
economies unavailable to the typical individual investor. Also, professional money
managers should be able to earn above average returns through successful securities
analysis. Moreover, mutual funds allow individuals to earn a certain return without
needing to constantly monitor the market.
These arguments assume that a diversified portfolio will reduce the risk, and that there
are certain opportunities for money managers to beat the market, due to the timing of
market corrections.
Index funds vs. actively managed equity funds.
Deciding between mutual and index funds is not a matter of attempting to assess which is
better, but simply a matter of selecting one's own personal investment style. Index funds
are specially attractive to more passive investors, who do not believe in constant
outperformance of the market.
The major attractiveness of index funds lies in their low cost for the investor. Low fees
and low turnover holds down transaction costs and minimizes capital-gains taxes.
Index funds are steady performers that have been trouncing the average mutual fund for
along time. They are great core holdings, particularly for beginning investors and anyone
who does not want to keep an eye on the market.
They are managed so that their returns will match, as exactly as possible, the returns of
a broad market index. If the overall market goes up, the index fund will go up almost
exactly as far. The most popular and well-known index funds track the Standard&Poor's
500, which is basically a group of the largest blue-chip stocks on the market.
Index funds are often criticized for chasing mediocrity; their returns will always be
slightly behind the market as a whole, by the margin of the (generally very low) expenses
charged to run the fund.
However, over the last 3-,5-,and 10-year periods, the indexes (and index funds) have
outperformed almost three-quarters of all portfolio managers. There are certainly
managers who have consistently beaten the indexes. But some investors are more
comfortable knowing that they will get whatever the market gives out, and they are not
subject to the whims of a portfolio manager who may or may not live up to his or her
track record. If you are a do-it-yourself investor who doesn't have a lot of time to
spend investigating the performance of individual mutual funds, then an index fund is a
relatively comfortable alternative.
This is the main reasoning of firms like Vanguard which has concentrated to a large
extent in index funds. Vanguard's $10.7 billion Index 500 Portfolio has been performing
quite well in the last few years. On the other hand, the $350 mill. Fidelity Market Index
or the T. Rowe Price are slightly more expensive and smaller, but have also been
performing well.
Other index funds that you might consider are BT (Banker's Trust) Pyramid Investment
Equity 500 Index Fund, First American Equity Index Fund or SEI S&P 500 Index Portfolio.
APPENDICES
Appendix 1 Performance measures 1977-87
Appendix 2 Current Performance(FMAGX)
Appendix 3 Risk-return performance
Appendix 4 Performance measures for 20 selected mutual funds
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