THE MONEY MACHINE

By JAMES COLLINS

These should be heady times for Fidelity Investments, the mutual-fund giant that manages $450 billion worth of other people's money--very probably including some of yours. The Dow Jones and Standard & Poor's 500 both hit record highs last week, confounding expectations that a serious stock-market correction was at hand. The flow of money into mutual funds this year is torrential, and has already set an annual record. But Fidelity, the biggest fund company of all, known for its arrogance and aggressiveness, is under unprecedented strain. Some of its biggest funds are lagging behind the benchmark S&P index not only this year but over the past three years as well. Investors are wondering, Is it just a bad patch, or are the company's glory days of whipping the industry gone for good?

"We're not going to be at the top of the list every year. You can't do that," says Fidelity chairman Edward C. Johnson 3d, known as Ned. In a rare interview, the man who created the money machine is quick to point out that though Fidelity's most popular fund, Magellan, is struggling, it "still beat 82% of all equity funds" last year. But Ned Johnson's company, along with every other mutual-fund operator, bank, brokerage and insurance company, finds itself in an escalating battle. As baby boomers save for retirement, college for the kids or a rainy day (say, when the Social Security system collapses), their investment rates will soar. Mutual funds have topped $3.145 trillion in assets.

Like Sutter's Mill, which in 1848 bestrode a gold-laden California stream, Fidelity has for years flushed a rising river of investment through its machine, enriching both customers and company. One out of every 50 households in America owns shares in Magellan, which has grown to a staggering $50.97 billion. Fidelity invests more money for the employee savings-and-retirement plans known as 401(k)s than any other institution: $111.4 billion.

But the claim jumpers are everywhere, ready to pounce on Fidelity, especially since they now sense a weakness at the heart of the company. Fidelity's long-term record may be unassailable, but the news this year continues to be bad: all 12 of its largest funds are trailing the stock market. Doubters are asking whether Fidelity, given its size, can deliver superior returns.

Last March Johnson shook the company to the rafters. In one of the most important changes in its history, he reshuffled the managers of 26 equity funds. (Seven months earlier, the managers of 21 bond funds had been reassigned.) Since March, some high-profile talent has walked--including Jeffrey Vinik, the manager of Magellan, in June.

Despite his shake-up, Johnson oversees a solid operation filled with top portfolio managers. And even as new stars such as Robert Stansky, who took over Magellan, hunker down to chase the Dow, Johnson is orchestrating a three-tiered expansion plan that he hopes will render the vicissitudes of the stock market less meaningful. Part of it involves boosting Fidelity's subsidiary businesses, which range from newspapers (Fidelity owns 117 of them) to limousines and software.

In mutual funds, Fidelity has led the way in customer service, and it aims to distance itself from competitors. The company pioneered such techniques as automatic transfers over the telephone, and is developing a slew of advanced phone and computer products to speed the transactions. Fidelity also sees new markets in the thousands of corporations for which it administers 401(k) plans (including this magazine's parent company, Time Warner). It wants to persuade those customers to let it handle data-dense departments such as medical insurance, human resources and payroll as well. The attraction for corporations is lower cost. The attraction for employees is one-stop shopping for everything from address changes to changing their pension contributions. The attraction for Fidelity is a very profitable business and the opportunity to develop a vast base of customers. Lastly, the company wants to export the whole works to countries such as Japan, where mutual funds and pension plans are decades behind those in the U.S.

The common denominator to all this is technology. Johnson is a techno-junkie who pours more than $500 million a year into making Fidelity a state-of-the-art operation. In its five phone centers around the country, customer reps have the most sophisticated terminals in the industry. The computer center in Dallas, which handles all the market data fed to analysts as well as Fidelity's trades, is far more advanced than any other such facility in the securities business. "It feels like NORAD," says an employee. Johnson's early decision to invest in the software and computer capacity to service the 401(k) business was crucial to Fidelity's rapid growth. But ultimately, neither strategy nor technology will matter if Fidelity can't deliver superior returns to investors.

Johnson, along with other Fidelity executives, insists that the company's homegrown style of managing portfolios doesn't need much fixing. Fidelity's rise to the top of the industry has been underpinned by what is called bottom-up investing-- basically outworking the competition, digging deeper for information, discovering growth companies before anyone else does and holding on to them until they blossom.

And Johnson is vowing to stick with it. If Johnson were still running the Magellan Fund at Fidelity today, he would arrive at Boston's One Federal Street, where the 48 fund managers and 81 analysts of the equity division toil. The atmosphere is more subdued than you would imagine in a place where billions of dollars are riding on the employees' bets. The staff is spread over three floors that are connected by an internal staircase, and stock analysts and fund managers wander around a lot, sticking their heads into one another's offices and trading information.

Sitting in his modest office, Will Danoff, manager of the nearly $19 billion Contrafund, talks about the huge sum of money he is investing. Danoff is a star--the fund's average annual return between 1990 and 1995 was about 22%, vs. 14% for the S&P 500 for those years. Printouts and annual reports are stacked on his chairs, desk, cabinets and floor; almost hidden in the mess are four computer screens. On one wall Danoff has hung a printout with a quote from Churchill to one of his generals: "What have you done to win the war?"

Asked what the difference is between running $300 million--the Contrafund's initial stake--and its present billions, Danoff, a rumpled 36-year-old, smiles and says, "I'm working harder." At this size, just buying or selling a meaningful amount of stock can be difficult. "I won't take a half-million-share stake in a day," he says. "I'll buy 50,000 shares a day for months to build up a position." Danoff is candid about the downside of running a fund so large: "You're racing a Mack truck against a speedster [i.e., a smaller, competing fund]. I go 45 miles per hour, and the speedster goes 70 miles an hour. But he may spin out at some point. I'll do well if I stay out of trouble."

Should investors be concerned that the size of Fidelity's funds makes them unwieldy? "It's a reasonable worry," Danoff says. "I would close my fund [to new investors] if I really didn't think that I could beat the market over time." That is the standard answer to this question from Fidelity managers, but of course, it's not really an answer; it's a promise.

Fidelity's investment techniques have historically produced market-topping returns--and commensurate fees. Beating the averages, such as the S&P index, is what Fidelity is being paid for. Magellan, for example, charges $9.50 each year for every $1,000 under management. By contrast, the Vanguard fund that passively mimics the S&P 500 charges only $2 for every $1,000. Overall competition in the industry has become so tough that Fidelity has had to lower fees on some of its funds.

The real test for a fund is beating an index like the S&P 500. If you can't beat an average, then you aren't investing with any more skill than you would if you chose stocks randomly. How hard is it to beat the S&P 500? Really hard. Over the past five years, 63% of all diversified-equity mutual funds have failed to do so. The greatest Fidelity performer of all, of course, was Peter Lynch. During his 14 years of managing Magellan, he averaged an annual return of 29.2%; the S&P 500 index rose 15.8%.

Producing new Peter Lynches is the entire purpose of Fidelity's equity division. Take Brian Posner, 35, who runs Equity-Income II, a fund with over $14 billion. Between 1992 and 1994, Posner outperformed the S&P 500 by wide margins, but in 1995 his results were lower by about 11 percentage points; this year he's just about even with the market. He calls himself "a quant from the University of Chicago," but he insists that the daily contact with the other managers and analysts is what really helps his thinking. He cautions new analysts against relying too much on technology. "I tell them, 'Don't let it become a crutch to eliminate face-to-face contact.' I want them to feel an emotional stake in this process." Like all the managers, Posner faxes his orders to his trader each morning and usually doesn't trade again all day. Eighty percent of his workday is spent on the phone to companies or meeting with executives. True to his metier, he relies heavily on corporate financial statements: "They tell me what can realistically be accomplished."

Much as the portfolio managers may share information, they run their funds solo. The company has never favored investment committees like those at banks and at most other mutual funds; it prefers young, cocky managers and gives them independence. The classic Fidelity approach is, "Here's some money; now be a genius." Typically, a new hire out of college or business school starts as an analyst and is also given a "small" fund--something in the range of $100 million--to run. Within a few years, the analyst should become a full-time manager, overseeing a moderate-size fund that will be allowed to grow to several billion dollars. The system draws criticism. "Can 31-year-old portfolio managers manage $10 billion portfolios on their own?" asks David O'Leary of Alpha Equity Research Inc., an institutional brokerage and research firm that tracks Fidelity's sector and stock movement. "They may be brilliant M.B.A.s, but they have no history of managing money in a bear market."

Fidelity relies on its workaholic culture to ferret out true investment warriors. "Not all the fund companies are that competitive," says Eric Kobren, the publisher of the newsletter Fidelity Insight. "People watch what time the lights go on and off in the office. How often do you get voice mail from your boss at 2 a.m.? It's a very common occurrence at Fidelity. They have a higher degree of competitiveness and a higher degree of obnoxiousness."

"The cost in human capital is extremely high," says a former executive. "It's a very tough place to work. You make your 20% or they cut your head off. This is honed to a razor-edge." This man pauses. "Fidelity is a great place to be from."

Despite the scores of analysts, the latest technology and hungry, keen-eyed stock pickers, something went wrong with Fidelity's fund management in the past couple of years. In 1993, 84% of its diversified U.S. equity funds outperformed the market; in 1994 about 51% did; last year the figure dropped to a paltry 21%. So far in 1996, 29% have done better than the market.

Why is Fidelity sputtering? Says George Vanderheiden, senior vice president of Fidelity Management & Research Co., which oversees all the firm's mutual funds: "In the past, we've done very well in up markets and underperformed in down markets, because we're fully invested. But over the life of the cycle, we've beaten the market." This explanation raises a question, however: If Fidelity does exceptionally well in bull markets, why didn't it show spectacular returns in 1995, which was one of the best years the market had in this century?

Results for April this year showed that for only the second time in two decades, the three-year return of Magellan had slipped below that of the S&P 500. Jeffrey Vinik, the manager of Magellan at that time, did not last long after these numbers came out; he resigned in May to set up his own investment firm. He was replaced by Bob Stansky, a 13-year veteran at Fidelity who is less likely than Vinik to make big sector bets.

Vinik typified the dual problem Fidelity has struggled with recently. On the one hand, it has had to contend with disappointing performance; on the other, it has come under criticism for being too unpredictable in its investments. Magellan underperformed because Vinik put an enormous chunk of the fund in bonds, believing that stocks were overvalued. Stocks kept going up, and Magellan's relative return suffered. The results numbers aside, there was the question of what Vinik was doing investing so heavily in bonds in the first place, since Magellan is supposed to be a diversified stock fund.

Fidelity was trying to balance performance and predictability when it shifted the fund managers last March. Some of the funds were not doing as well as they ought to have been, and many were wandering far from their ostensible mandates. The Blue Chip Growth Fund, for example, was heavily invested in small and midsize companies. (Its manager, Michael Gordon, left Fidelity to work with Vinik.) Asset Manager, which was supposed to be a low-risk diversified fund, had 18% of its holdings in Mexican debt in 1993.

So long as returns were good, it was easy enough to ignore these anomalies. "Yes, Fidelity got too far out and needed to tighten up," says Fidelity Insight's Kobren. "When everything is working, no one focuses on this. Who cares about volatility if you're on the upside? Who cares if the Contra Fund is not contrarian; if Capital Appreciation is not really a capital-appreciation fund?"

Fidelity's response has been to match up managers more closely with the funds' stated aims, so that someone who is keen on small stocks is actually running a small-stock fund. The company will also oversee its fund managers more closely. They used to be divided into four groups for supervision; now they will be divided into eight.

No one at Fidelity will say that the changes indicate the company is becoming more conservative or reining in its young stars. Roger Servison, executive vice president of Fidelity Investments, says the company has "tweaked" the system. "It was not totally reinvented," he says. "But there is more control over risk management and better coordination within and among groups to avoid duplication." Adds Vanderheiden: "The culture of performance is still there. But they're saying, 'Take a little of the amplitude off the bottom and the top.' People here are grappling with how to do that." (To an outsider, taking the amplitude off the bottom and the top implies taking fewer risks and accepting a lower return.) Vanderheiden also suggests that lower returns than those achieved in the '80s and early '90s are inevitable. "People have their expectations too high," he says. "Their expectations shouldn't be 15% a year, or even 10% a year." Rather, "mid-single-digit returns" are realistic.

The clients, and potential clients, whose expectations Fidelity must now worry about more than ever are the corporate sponsors of 401(k) plans. At the end of 1993, Fidelity had $37.5 billion in 401(k) money under management: 9% of the market. Four years later, the company had sucked in more than $111 billion and nearly doubled its market share. Because 401(k) contributions are automatic month after month, they represent a constantly self-replenishing source of capital for investment--an enormous advantage for the company that controls them.

The battle for the 401(k) market is expected to get nasty. "The competition is incredible right now. Incredible!" says Christopher Zyda, director of investments for the Walt Disney Co., who oversees $1.3 billion in 401(k) money for its employees. "We've looked at some of Fidelity's key competitors and realized that the fee structure has decreased significantly. As a result, we were able to negotiate a much better fee structure with Fidelity."

The 401(k) sponsors have a tremendous influence on the way Fidelity manages its portfolios. Those managers are reported to have been prime instigators of the changes that Fidelity made last March. Although Fidelity tries to downplay such corporate pressure, Vanderheiden acknowledges that it was "one of the top three of four" reasons for the moves.

The 401(k) sponsors are also gatekeepers to Fidelity's expansion plans. Johnson is, in the words of an associate, "a sucker for a good idea," and Fidelity's hottest one is to leverage its massive technology infrastructure. Since Fidelity is already handling record keeping for pension plans, the reasoning goes, why not take on other corporate bureaucracies, notably benefits plans, payroll and human resources? In today's penny-pinching corporate environment, these areas are "non-value adding." In other words, they cost money, so why not bid the work out?

This strategy is an extension of Johnson's obsessions with technology and service. Besides, as Johnson says, "the history of equities is highly cyclical. Processing you do every day." Paul Hondros, who headed Fidelity's institutional-services division until taking charge of the retail business last week, puts it more emphatically: "The future is not about Magellan, despite all the press coverage. Markets come and go. This is a big diversification play. The future is technology-based service." Such service complements the investment business as more than just a hedge, though. By tracking all that data, Fidelity would gather information on the financial conditions and habits of a huge number of potential clients for its financial services. It would turn around and make customers of them while they are working and then hope to manage their money when they retire.

Johnson is also driving the company well beyond the U.S. In Japan trillions of yen have been figuratively kept under the mattress, locked into low-interest savings accounts. That money is becoming unlocked--and Fidelity wants a piece. In December, Fidelity became the first U.S. company to launch a yen-dominated investment trust in Japan. In Britain defined-contribution plans similar to 401(k)s, as well as mutual funds, are just beginning to take off, and the company is investing heavily.

No one doubts that with its talent, dominant share of the 401(k) business and investment in technology, Fidelity can remain the industry leader for the foreseeable future. But with greater price competition, the constraints on individual genius and the burdens of size, there may be fewer opportunities for Lynch-like glory.

Finding those opportunities will be Johnson's mission, and Fidelity's frenzied troops will no doubt turn up the dial. They know that as great as the company's service is and as promising as its various ventures may be, consumers can't send their kids to college or buy that vacation home unless Fidelity is in the money. As a former employee says, performance is the sine qua non; if Fidelity does not get back into the top 10%, the whole operation may stall.

--Reported by Sam Allis/Boston with Bernard Baumohl/New York

With reporting by SAM ALLIS/BOSTON WITH BERNARD BAUMOHL/NEW YORK