The Fidelity Magellan Fund

The Fidelity Magellan Fund Investment Evaluation Report 1995 The Fidelity Magellan Fund is a mutual fund. Mutual funds are professionally managed portfolios that have specific portfolio strategies. Some contain all stocks, some are all bonds and some are balanced between stocks and bonds depending on external economic and market conditions. The Fidelity Magellan Fund is currently composed of approximately 98 % stocks1. 56 % of the stocks are also found in the Standard and Poors 500 index (S&P500). The S&P 500 is an index made up of five hundred different stocks. Each is selected for liquidity, size, and industry. The index is weighted for market capitalization. The S&P 500 is a benchmark of the overall market, and frequently used as the standard of comparison in terms of investment performance. Furthermore, the Magellan has currently invested 17 % in the S&P Mid and 22 % are in the US Small Cap. A minor % is invested in foreign companies. The fund is furthermore leaning heavily towards the technology sector (43 %) followed by financials, industrial cyclical and services, all between 11-17 % each. The technology sector is furthermore focused towards IT and Materials. In trying to foresee future performance of Magellan, it is useful to see behind the previous returns and see if there are specific reasons that can explain the on average best-in-class perception of this fund. The past performance of Magellan can be evaluated compared to e.g. other standard indexes, market segments or to other similar funds. Starting with the latter, Magellan has the last decade been rated with 5 stars from the Morningstar Rating System. This system, related to funds, tried to describe how well a fund has balanced return and risk or volatility in the past2. The Morningstar Rating for funds is a descriptive, backward-looking measure of historical performance. It combines return and risk (volatility), and compares funds with their peers in specific investment categories. To calculated return and risk, one often uses the Sharpe ratio. The Sharpe ratio is used to measure risk-adjusted performance. The Sharpe ratio is calculated by subtracting the risk-free rate - such as that of the 10year U.S. Treasury bond - from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns3. The Sharpe ratio tells us whether a portfolio's returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance has been. Magellan’s ratio is currently 1.48, determined as good. If is furthermore worth to notice that the Morningstar is a fixed distribution of stars: 10% of funds within each category receive 5 stars, 22.5% receive 4 stars, 35% receive 3 stars, 22.5% receive 2 stars, and 10% receive 1 star. Since Magellan has currently only 4 Morningstars, there

are currently other similar funds giving you a better return with similar risk within Magellans category “Growth”. If we compare the Magellan fund to other standard indexes, like the S&P500 and the Wilshire5000, we see that the fund has given an additional rate of return the last 3-10 years of approximately 4-7 % compared to these indexes1. In trying to forecast next years return of the Magellan fund, compared to e.g. investing in S&P500, we can calculate the annual returns and the standard deviations (Table 1).

  However, it is important to include also all fees associated with a mutual fund like Magellan. The fee it carries is an annual brokerage fee of 0.25 %, a sales fee of 3 % and a management fee of 0.75 %1. Thus a considerable amount of the additional return is lost in fees. Furthermore, a key evaluation element is also market efficiency, and to see how this has changed the last couple of decades. The market efficiency hypothesis states that a stock price already reflect all available information, that is, immediately when new information related to a specific stock emerges, the information is quickly disseminated with a subsequent move of the stock price that match the new information, being good or bad5. Thus, being the first to uncover new unique information relevant for the stock price gives the investor the chance of either “first-in” or “first-out”, before the information becomes common knowledge. The often such opportunities arise, the more likely one is to beat the general market. In the late 70ties, Roger Lynch exploited the fact that the competition was relatively low compared with today’s market, and that the Magellan fund was such of magnitude that it could afford staffing a large amount of researchers and analysts as even a minor improvement in annual return could alone cover this staffs expenses This staff also allowed Magellan to be heavily exposed to the small company stocks, a segment that during the eighties could show a much better return of investment than mid to large size companies. This was partly due to many of the firms within this segment was being neglected by analysts, and thus the market was not as efficient within this segment, compared to e.g. S&P500. It is interesting to note that Lynch specifically tried to target neglected firms where the competition from other analytics was small listed in his “favorable attributes” of stocks to invest in.

Being successful in this, the ability of Magellan to show incremental improved performance had a strong positive effect on the amount of invested in the fund, and also resulted in investors keeping their money in the fund longer than average. Looking at Magellans performance, many funds started to hire more and more analysts to try to pick cheap underrated stocks for future boosted return of investment, and during the last decade, the number of mutual funds grew from approx. 1500 to 6500. This resulted in a massive increase in analysts, and thus the easy picks got rarer and rarer due to increased competition. This competition has lead to improved market efficiency, since it’s quickly publish and disseminate new information relevant for specific stocks. However, it also means that the Magellan fund today has less first-mover chances than before. Another benefit the Magellan fund had earlier was its shear size and in many ways it functioning as a major determinant of a stock price, if the fund decide to heavily buy or sell a stock. At any given time there will be a share of current stock holders that want to sell their shares, some cheaply and some will sell for a bit more. When a fund like Magellan move into a stock, it immediately pick all the lowest priced stocks, but also drive the stock price up-ward. The fund then also benefit from the momentum effect, found by Jegadeesh and Titman5. The momentum effect being that good or bad recent performance of particular stocks continues over time. This effect is partly explained by the fact that not all investors and fund managers are highly analytical and rational, and use irrational signals for their investment decision, e.g. a continuous up-ward trend in the stock price. Taken together, Magellan has shown great performance over a number of years, mainly due to Lynch excellent performance. This success caused many traders and portfolio mangers to piggy-back on Magellan moves, which again gave Magellan a benefit, especially when investing. However, the Magellan is today of such a size that it more or less reflects the market as a whole, and thus one can question if it is wise to pay such a “mirror” the fees that follows. It is also likely that the market has become more efficient than before due to higher competition, making it harder to get under-rated stocks. As shown in Magellans investement prospect, their annual return the last five years varies between e.g. -4.51

% in 1990 to 41.03 % in 19911. Thus, deciding upon what to invest in also then depends on the expected holding period. Furthermore, analysis has also shown that a fund will not sustain its performance over time, depicted in Exhibit 87. When also adding in the fees associated with Magellan it is hard to see that investing will be a wise decision. Taken together, it is thus unlikely that the fund will be able to sustain its great performance also in the future. However, the market cannot be perfectly efficient or there would be no incentive for professionals to uncover the information that gets so quickly reflected in market prices, a point stressed by Grossman and Stiglitz6. If Magellan is the vehicle that can exploit this fact better than other funds, and that they can dot his consitently compared to a broad index is however unlikely.

1. Fidelity Magellan Fund case, Exhibit 4 2. http://news.morningstar.com/articlenet/article.aspx?id=4982& 3. www.investopedia.com 4. Fidelity Magellan Fund case, Exhibit 1 5. Bodie, el. al. Investment and Portfolio Management, 9th edition, Ch. 11, 2011 6. Grossman et. al. “On the Impossibility of Informationally Efficient Markets,” Am Econ Rev (1980) 70, 393-408. 7. Burton, G.M. “The Efficient Market Hypothesis and its Critics”, (2003) CEPS Working paper No.91