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THE BUY SIDE - Course Correction

Fidelity reinvents its research arm in search of better performance.

Turning around a tanker isn't easy, but that's exactly what the top brass at Fidelity Investments has been trying to do since the spring of 2005, when chairman Edward Johnson III and vice chairman and chief operating officer Robert Reynolds concluded that a major revamping of the firm's research division was needed to reverse mediocre performance.

Judging by the contents of Fidelity's 2006 annual report, released on February 16, the mutual fund colossus still has a ways to go. Just 58 percent of its equity funds beat their peers last year, down from 70 percent in 2005, the firm reported. Net income dropped for the first time since 2002, falling 11 percent to $1.18 billion.

Nonetheless, Fidelity management remains confident that the ambitious overhaul will yield results. Under former chief financial officer Stephen Jonas, who became head of the money management unit in May 2005, the firm has invested $100 million, doubling its U.S. team to 180 analysts while expanding its research presence in key markets abroad. Fidelity has also reorganized the division to improve creativity and foster more collaboration among analysts. Some portfolio managers have been replaced.

Today the firm is not quite halfway through what executives view as a four- to five-year strategy. "We are early in this game," says Reynolds. "We manage $700 billion in equities today. We're looking out to how you manage $1.4 trillion or even more."

Veteran Fidelity watchers like what they see. "The changes were necessary and long overdue," says Eric Kobren, executive editor of newsletter "Fidelity Insight." "Fidelity was playing not to lose instead of playing to win."

The shake-up has been top-down from the start. Jonas succeeded Abigail Johnson, the chairman's daughter and heir apparent, who spent her entire 20-year career at Fidelity in money management; as head of the business she had been supervising analysts and portfolio managers. In May 2005 she was put in charge of the firm's 401(k) unit. "She grew up with these people, so it was tough to be their boss," says Kobren. Johnson's move reflects Fidelity's tradition of having executives serve in a range of roles.

In early, high-profile decisions, Jonas hired new managers for two of the firm's biggest funds, Fidelity Magellan and Fidelity Growth & Income, which both underperformed their benchmarks in recent years. In early January, though, Jonas himself resigned to spend more time with his family and pursue nonprofit work. Reynolds stepped in to oversee Fidelity's rehabilitation effort.

Although Fidelity's portfolio managers remain firmly in charge of buy and sell decisions at their funds, the changes have upended many long-held practices in the research division. In a departure from Fidelity's tradition of hiring and training new graduates, half of the firm's recent recruits have been experienced analysts brought in from industry or from other investment firms, says Walter Donovan, who became president of the equities division when Jonas retired.

Fidelity has improved its reach and range. Analyst head counts were increased in Australia, France, Germany, Hong Kong, India, Japan, South Korea and the U.K. These hires have enabled the firm to add to its international automakers coverage, for example, and to look deeper into outsourcing by information technology service companies. Brian Hogan, Fidelity's head of equity research, says the firm has increased its stock coverage universe in natural resources and real estate by 40 percent, in telecommunications and utilities by 30 percent, in health care by 15 percent and in technology by 10 percent.

In perhaps the biggest cultural shift, Fidelity has also created a new career path for analysts, who traditionally rotated through sectors every year or two, with the goal of running a diversified mutual fund. This practice created fund managers with knowledge of multiple industry groups, but it also weakened the continuity of coverage and limited analysts' ability to develop deep experience in an industry. Now Fidelity is keeping analysts in place longer so they can build experience. Reynolds says the firm will reward those who want to run money by putting them in charge of one of the firm's 40-plus sector-specific "Select" branded funds (more than half of which have had a change of management in the past year).

Fidelity's sell-side counterparts have noticed the changes. "They need us less because they're more experienced," says one veteran Wall Street researcher who asked not to be identified. "Fidelity's quality has clearly been upgraded."

Improving creativity has been more of a challenge. As part of its reorganization, Fidelity has hired a new team of ten "diversified" analysts for large-cap stocks who can perform thematic research on companies or industries that pique a portfolio manager's interest but are not covered elsewhere in the firm. It has also organized its research group into eight sector-based teams, which take cross-asset-class and multisector looks at industries. An August 2006 internal homebuilding symposium brought together banking, finance, economics and fixed-income analysts to brainstorm investment ideas. In January equity, fixed-income and high-yield analysts from around the globe who follow technology and related sectors like electronics retailing gathered for a conclave in Boston. "Hopefully we'll get more stocks right," Hogan says of these efforts.

Fidelity is even making changes to its office space. To improve communication, the firm moved the entire investment group to a new building in Boston in January that offers more square footage per floor, and executives are configuring floor plans that group analysts, traders and fund managers closer together.

The prize, of course, is asset growth, and on that count Fidelity is showing progress. In 2006 mutual fund assets grew by 14 percent, according to Financial Research Corp., and Fidelity was the only firm among the seven biggest fund managers whose net inflows outpaced those of the year-ago period. Reynolds figures that better research will ultimately yield the performance needed to sustain flows. "We expect to get more than our fair share," he says.

THE FACTS


FIRM: Fidelity Investments


NUMBER OF EMPLOYEES: Nearly 40,000


ASSETS UNDER MANAGEMENT: $1.4 trillion as of 12/31/06

NO. OF EQUITY MUTUAL FUNDS: 296


NO. OF BOND MUTUAL FUNDS: 43