Within institutional investing, the paradox of skill is a familiar concept. When the level of competition rises, the best contestants perform worse.
It’s one thing to beat up on second-rate rivals; it’s quite another to excel against a strong field. Famously, the evolutionary biologist Stephen Jay Gould applied this postulate to baseball, arguing that that Major League Baseball hasn’t had a .400 hitter since 1941, not because batters are worse, but because pitchers have become better.
The retail mutual fund Fidelity Magellan (FMAGX) exemplifies this institutional idea. These days, Magellan attracts little attention. It is an unremarkable 3-star large-growth fund, slightly lagging its Morningstar Category average over the trailing 10 years. Ho hum.
But things were once very different. During the first half of its existence, the fund showed what trained portfolio managers could accomplish--when the competition consisted mostly of enthusiastic amateurs.
The Wonder Years
Magellan was founded in 1963, as an “incubator fund” available only to Fidelity insiders. The fund would not open to outsiders until 1981, a full 18 years later. Thus, its initial results require a large asterisk. As incubated funds tend to be tiny, they often invest speculatively, by trading rapidly and/or holding very tiny companies.
Such strategies cannot necessarily be continued after they open their doors. Incubated funds also benefit from their shareholders’ predictability. They need not struggle to meet unexpected redemptions nor to invest sudden inflows.
That said, the incubated performance of Fidelity Magellan was breathtaking. From inception until going public, Magellan outgained the Ibbotson Large Stock Index by an annual 15.9 percentage points.
For comparison’s sake, the largest victory over the past 18 years that a diversified, nonleveraged fund has recorded against that index has been an annualized 7.4 percentage points, by Baron Partners (BPTRX). (That strikes me as a sector fund, and thus an unfair comparison, but who am I to quarrel with Morningstar’s categorisation?)
For amusement’s sake, I present a “growth of $10,000” chart for Fidelity Magellan versus the index over that 1963-81 period.
(Properly speaking, Growth of $10,000 charts should use a logarithmic scale, which eliminates the hockey-stick effect by equalizing all percentage changes, so that an increase from $10,000 to $20,000 occupies as much space on the graph as does a move from $100,000 to $200,000. But doing that would be no fun.)
Admittedly, the Ibbotson Large Stock Index is a flawed benchmark. During its incubation years, Magellan preferred small companies. The Ibbotson Small Stock Index therefore makes for a better measure. It also provides a sterner test, as small stocks thrashed large companies during that period. (That showing prompted academic researchers to suggest that, over time, small stocks will outgain blue chips. As Tuesday’s column related, that did not come to pass.) Against the Ibbotson Small Stock Index, Magellan’s annual lead shrinks to 7.4 percentage points.
Well, OK. When suitably benchmarked, the incubation version of Magellan continued to look excellent. But its relative performance was no better than that recorded by its modern equivalent of Baron Partners. Why all the fuss, then?
Rise and Fall
The next nine years answer that question. Within 18 months of Magellan’s public appearance, the fund had ballooned to 30 times its previous size.
In doing so, it lost much of its investment freedom. At $2 billion (in real money; had the fund been a publicly traded stock, it would have been among the nation’s 200 largest), Magellan was forced to supplement its small-cap stocks with blue chips. And its shareholder base was no longer stable.
Yet the fund remained excellent. For the next nine years, until manager Peter Lynch retired, Magellan compounded assets near its previous rate, gaining 22.3% per year. During that period, the fund no longer correlated so highly with small-company indexes. A more appropriate comparison, given Lynch’s catholic tastes (the pun is accidental), is a blended benchmark that consists of 50% Ibbotson Large Stock Index and 50% Ibbotson Small Stock Index.
That blended benchmark appreciated by an annual 13.7%, thereby giving Magellan a 9.6-percentage-point edge. In other words, after going public, Magellan increased its margin over the most relevant stock index, even while carrying the investment and public-relations burden of being the world’s largest mutual fund. There are, of course, no similar cases today. The only current funds that boast anything like Magellan’s 1981-90 results are both specialised and much smaller than the industry leaders.
The three decades after Lynch’s retirement brought Magellan back to earth. The fund continued to thrive for the next three years, hit a bump during 1994 when then-manager Jeff Vinik raised cash while stocks were rising, and then became thoroughly ordinary.
Its 30-plus year record is pretty much as Jack Bogle depicted the fate of actively managed stock funds: able to stay within sight of the indices but not good enough to exceed them once their expenses are paid.
An Unfriendly Trend
At first glance, this tale seems to be more about Peter Lynch’s superiority than the paradox of skill.
However, Magellan excelled for more than three decades, from mid-1963 through early 1994. Lynch was in charge for only 13 of those years. The fund was in other hands during most of the incubation period, as well as during its three excellent post-Lynch years. Without question, Lynch was the most talented of Magellan’s chiefs. But he was not its only successful portfolio manager.
Ultimately, changing conditions grounded Magellan, not Lynch’s departure. Through the first half of its existence, the fund was fortunate enough to operate when retail stockbrokers and their clients dominated equity trading. In such a climate, a truly exceptional investment professional could post truly exceptional returns. Now, however, institutional investors determine equity prices (meme stocks excepted). No longer can a mutual fund perform as Magellan once did.
Misreading the Tea Leaves
The attached note jogged my memory. When Peter Lynch retired, many observers interpreted his decision as an implicit criticism of the stock market. Lynch was getting out on top, leaving those who remained in equities holding the bag. For four months, this argument appeared prescient, as stocks promptly fell during summer 1990. Then followed the longest bull market in U.S. history. Mind reading is a difficult task.
John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with his views of the Rekenthaler Report, they are his own
