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The Fall of an Investing Superstar

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When it comes to identifying superstar investors, Peter Lynch ranks right up there along with the likes of Warren Buffett and Benjamin Graham. Lynch headed up the high-flying Fidelity Magellan Fund (FMAGX) from the late 1970s through 1990, in which time the fund handily trounced the wider market, earning nearly double the S&P 500's return on an annualized basis. Money flowed into the fund, fast and furiously, and by the late 1990s, Magellan was the single largest mutual fund in existence. However, since that time, the fund has fallen on some hard times and is struggling to regain some of its former glory. Fortunately, Magellan's life story offers some important lessons for mutual fund investors of today.

Fall from grace
Fidelity Magellan is a perfect case study of how a reversal of fortune can happen to even the hottest of investments. Today, Magellan is a shadow of its former self, with only about one-fifth of the asset base it boasted during its turn-of-the-century peak. Performance hasn't been anything to write home about either, as Magellan currently trails 77% of all large-growth funds over the past 15 years and lags the S&P 500 by an annualized 1.8 percentage points during that time.

Current manager Harry Lange's recent letter to shareholders acknowledged that weak stock picking had weighed on returns. Lange admitted that poor picks in the information technology and consumer discretionary sectors detracted from results. While mining stocks Goldcorp (NYSE: GG  ) and Newmont Mining (NYSE: NEM  ) helped boost returns, they weren't enough to boost the fund over the market rate of return hurdle. In fact, the fund now ranks behind 86% of its peer group in the past five years, the length of Lange's tenure.

But it would be unfair to blame all of the fund's problems on Lange. The fund was in trouble long before he came onto the scene. Looking at Magellan's example, there are some important reminders for all mutual fund investors.

1) A fund is only as good as its manager
Too many investors look only at a fund's recent trailing returns in making buy decisions. The far more important criterion is how long the existing manager has been on board. A top-rated 10-year record doesn't mean much if the manager has just been replaced. Magellan made its name on the back of Peter Lynch's superior stock picking skills, but once he left, the fund was no longer the same entity. The fund has had four managers since Lynch gave up the reins, but none was able to replicate his level of success. Manager tenure and track record managing money in the same style as the current fund are the first things investors should consider before buying a fund.

That's one reason why I tend to prefer funds that are managed by a well-oiled team rather than by one superstar manager. This way, you don't have to worry about potentially having to sell your fund if the manager leaves or retires. For example, one of Magellan's large growth competitors is PRIMECAP Odyssey Growth (POGRX). While the fund doesn't have an extended track record yet, I like the team approach here. A five-member team ensures that the portfolio is not overly dependent on any one person.

Currently, the team is leaning heavily into the health care sector, with picks like biotech firms Amgen (Nasdaq: AMGN  ) and ImmunoGen (Nasdaq: IMGN  ) . Management feels that the U.S. has a competitive advantage in the health care field relative to the rest of the world and that high-quality firms like these should enjoy greater than average growth prospects in the coming years. This fund isn't without risks, but growth investors who can take a few bumps in the road should do very well here without having to worry about a star manager jumping ship.

2) Size does matter
Some of Magellan's problems likely came from its incredible size. It's not an easy task to manage $100 billion in assets. Managers of extra-large funds are limited in the stocks they can buy, since they can't buy enough of smaller companies to make a meaningful impact on the portfolio nor can they buy significant positions in small-fry stocks without moving the market. The bigger a fund gets, the more risk it runs of looking like the index. Magellan likely got too big, too fast a decade ago, making the bloated fund more difficult to manage.

This has important implications for today's super-large funds. Several funds from the American Funds line-up clock in with more than $100 billion in net assets and the current No. 1 size champ, PIMCO Total Return (PTTAX), has more than $250 billion under its belt. So far, their asset load hasn't shown signs of slowing them down, but that could become a concern down the road. Investors in megaasset funds like these should be watchful for signs of asset bloat and realize that their fund's size may make a repeat of prior years' performance more difficult.

3) Top-ranked funds won't always be on top
It can be hard for performance-chasing investors to grasp, but even the best managers and funds won't stay at the top of the charts forever. While carefully selected managers should be able to beat the market over the long-run, every manager or fund will encounter periods of underperformance from time to time. In fact, if a fund has consistently ranked at the top of its game, that means it's actually more likely that it will drop in relative standing before too long.

For example, take Fairholme (FAIRX), which currently ranks in the top 1% of all large blend funds over the most recent 3-, 5-, and 10-year time periods. While a lot of money has flowed into the fund as a result, it's important to recognize the fund won't always look this good. Manager Bruce Berkowitz is taking a huge bet on the financial sector, stocking up heavily on beaten down stocks AIG (NYSE: AIG  ) , Citigroup (NYSE: C  ) , and Bank of America (NYSE: BAC  ) . If financials falter, the fund will be hit hard and a good number of investors will likely jump ship. While the fund remains a solid long-term investment, keep in mind that it won't stay at the top of the heap forever.

While few shareholders have been encouraged by recent results at Fidelity Magellan, I wouldn't ring its death knell just yet. I do think Harry Lange is actually a good stock picker, certainly better than what his current record indicates. Given its reduced size and focus on reasonably valued growth names, there could be better days ahead for Magellan. It may never regain the height of its popularity reached in the late 1990s, but it may have a shot at a more subdued second life.

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Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. Amanda owns shares of Fairholme. ImmunoGen is a Motley Fool Rule Breakers selection. The Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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  • Report this Comment On December 01, 2010, at 1:22 PM, AnthonyDuBon wrote:

    Great points.

    1) A fund is only as good as its manager

    Actually, it is the fund organization that matters, utilizing teamwork of smart people, excellent decision making processes, and strong leadership from the manager.

    2) Size does matter. The quality of the organization becomes more and more critical as the fund grows in size. Pimco total return fund is beating the trend. Fidelity's Contra fund is another example.

    3) Top-ranked funds won't always be on top. Agreed. They will not always be on top, especially those that are well publicized and grow into the problem of enormous size.

    I would like to add another point:

    4) Funds with lower risk often have higher returns. For a 10 year time horizon, FAIRX, PTTAX, FCNTX and POGRX, all have significantly lower risk measured by std deviation of daily returns than the S&P 500. For a 5 year time horizon, FAIRX, PTTAX, FCNTX FAIRX have lower risk than the S&P, POGRX is slightly higher risk than the S&P. Magellan has significantly higher risk in both time periods. This belies the often stated assumption that higher returns require higher risk.

    The analysis analysis above was conducted using FundRevealSM a new analysis tool available on the web. The tool allows you to identify funds most likely to outperform based on historical analysis and the proprietary mutual funds persistence rating. Basic analysis is free. Give it a try and conduct your own analysis.

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