Paul B. Farrell

Investors overpay Magellan by $330 million

By Paul B. Farrell, CBS.MarketWatch.com
Last Update: 12:03 AM ET Feb 21, 2003

LOS ANGELES (CBS.MW) - This is a simple test question to see how smart you are about mutual-fund expenses.

Investors pay the Fidelity Magellan Fund (FMAGX) $429 million annually to manage their $55 billion. In contrast, investors pay Vanguard $99 million to run the Vanguard 500 Index (VFINX) , also a $55 billion fund.

My question is simple: What is Fidelity doing with the extra $330 million taken from investors? Or, more accurately: What are Fidelity's investors getting that Vanguard investors aren't? That's a helluva lot of extra money.

Here's a hint: Nothing ... but I'm getting ahead of myself.

When I put the question to Fidelity's staff, they were quick to tell me that Magellan's 0.78 percent expense ratio is half the average 1.46 percent ratio for all stock funds.

But, of course, that's misses the point. Here's the real comparison: Magellan's 0.78 percent expense ratio is over four times Vanguard 500's, which is a mere 0.18 percent. So Fidelity winds up with $330 million more than Vanguard each year.

But, you say, Magellan is an actively managed fund and Vanguard 500 Index is just a simple index fund that a high school kid could manage on a cheap laptop over Pepsi and pizza during recess.

How do I know? Because five years ago Gus Sauter, the guy who manages $200 billion of Vanguard's index funds, told me when he started with the S&P 500 index he was using an old "286" computer. Remember, there are only 500 stocks in the S&P 500 and they don't change much. You could put all the data on one CD, maybe even a floppy disk!

Magellan "enhanced"

Magellan's rationale for charging $330 million more than Vanguard's S&P 500 fund every year is simple: They provide active-management to enhance performance and beat the S&P 500. Here's how Magellan's manager Robert Stansky described his strategy in a Money interview with Jason Zweig a couple years ago:

"How do you beat the S&P 500?" Stansky asked rhetorically: "You beat it by over-weighting some groups, under-weighting others, and by owning stocks that aren't in the S&P. Sometimes I think if people knew how risky I was acting in the portfolio they'd really be surprised. Just go back a bit: I made AOL very big; I made Yahoo very big. I'm not afraid to make any bet." Bragging about big bets on AOL and Yahoo?

Bottom line: Stansky's goal is very simple: Beat the S&P 500. More specifically: Beat the Vanguard 500 Index Fund.

Magellan's an "index fund in disguise"

However, if you compare the portfolios of the two funds you'll see they're actually quite similar. Which reminds me of a remark Ted Aronson of A+J+O, pension managers handling $7 billion, made to me recently -- that all actively-managed funds are just "index funds in disguise." So, Magellan is an index fund in disguise, while charging an outrageously high fee for little value-added.

Here's another example of Stansky's management. Look at the two portfolios. Both share seven the same top-10 holdings and in very similar percentages: Microsoft, GE, ExxonMobil, Wal-Mart, Pfizer, American Int'l and Citigroup. Should investors pay $330 million for those kind of boring stock-picking decisions?

What about the other three stocks? Magellan substitutes Viacom B, Wells Fargo and B/A in their top-10 for Coke, J&J and IBM, which must be in Vanguard, to mimic the S&P 500 allocations. So at best, you could say Magellan is an "enhanced index."

But the plain truth is, Magellan is really just another boring easy-to-manage S&P 500 index. And Stansky's so-called "big bets" hardly deserve $330 million extra a year.

Magellan investors pay $330 million for nothing

Unfortunately, Magellan isn't beating the S&P 500 or Vanguard! Quite the opposite, Vanguard 500 Index is beating Fidelity Magellan on a one, three and 10-year average basis. And that's on a pre-tax basis, folks.

In other words, Fidelity investors are forking out a $330 million expecting Stansky to deliver on his promises, but getting nothing extra in return. This charade has been going on for a decade.

And to make matters worse, while Vanguard is a no-load, Magellan forces investors to pay an extra 3 percent front-end load for the privilege of investing in this pseudo-index fund. Moreover, since that extra 3 percent is not included in their expense ratio, Fidelity's investors are losing even more money than the $330 million.

When I ran this by Kevin Johnson, Ted Aronson's partner in AJO and Gus Sauter's predecessor at Vanguard, Johnson had this to say about Magellan as an index fund in disguise: "For an organization that prides itself on its active management style and research capabilities, that's surprising. Sounds like somebody's collecting an awful lot of money." But for what?

Evidence funds "stealing" from shareholders?

Question: Where does all that money go? Answer: In the owner's pockets. For example, while Magellan shareholders lost over 40 percent in the past three years, the Forbes 400 list of America's richest billionaires reported that the net worth of Fidelity's two owners, Edward Johnson and Abigail Johnson, increased from $11.1 billion to $12.3 billion between 1999 and 2002, making them the 19th and 38th richest people in America.

Vanguard, on the other hand, is owned by its 14 million individual shareholders. Spokesman Brian Mattes tells us that "Vanguard operates on cost basis, so it returns all profits, after expenses, to shareholders." So there is no gross profit markup payout for the owners. Mattes also says this is "the primary reason why Vanguard's expense ratio is so low," the benefits are passed on to shareholders.

When investors recently read that Congress and the GAO were investigating fund expenses, a cheer when up. Something is seriously wrong in the fund industry today, when the shareholders lose 40 percent while the owners gain 10 percent and put $1.2 billion more in their pockets.

Actually, it's even worse: Fund managers' compensation also increased 35 percent between 1999 and 2001. Plus fund directors voted themselves a 26 percent raise between 2000 and 2002. They now make an average of $249,500 for part-time work.

Investors "mad as hell" at the conspiracy

Something is definitely rotten in the fund industry with this kind of larceny running rampant and unchecked. Did I say "larceny?" Actually, I was going to soften things, and use the term "largess."

But I'm angry! America's funds have crossed the line from simple largess to grand larceny. We've lost huge sums during this three-year bear market, while this conspiracy of fund owners, managers and directors are looting the treasury. We should be mad!

Now you got another reason to index!