Fidelity seeking to pump up institutional bond muscle

BOSTON — Fidelity Investments, a Goliath among retail fixed-income investors, is more of a David in the institutional bond business. But the money manager is arming its slingshot and taking aim.

Consultants and pension executives give Fidelity credit for gaining momentum in recent years, but predict it will be tough for the Boston-based firm to break away from the pack chasing institutional fixed-income heavyweights like Pacific Investment Management Co., Western Asset Management Co. and BlackRock Inc.

Some observers are willing to give Fidelity an edge among firms looking to close the gap with the behemoths in the bond business, citing the driven, long-term competitive nature of the company and its chairman and chief executive officer, Ned Johnson. "If anybody can do it, they can," said Donald H. Putnam, founder of New York-based Grail Partners LLC, an investment banker to the money management industry.

Fidelity managed $65.2 billion in investment-grade bond mutual fund assets as of March 31, up sharply from $29.9 billion at the end of 1999, spokesman Scott Beyerl said. Fidelity has firmwide institutional investment-grade bond assets of $15.5 billion, of which defined benefit mandates account for roughly half, or $7.9 billion. As a retail bond manager, Fidelity's $65.2 billion, together with $25.2 billion in high-yield bond funds, still leaves the firm behind PIMCO's $110 billion in fixed-income mutual fund assets, but well ahead of institutional heavyweights such as BlackRock, which has $25.4 billion.

In an interview, Drew E. Lawton, president and CEO of Fidelity Management Trust Co., said the risk-controlled, bottom-up operations of the firm's investment-grade bond team, based in Merrimack, N.H., delivers consistent returns and "no surprises" — a perfect recipe for institutional investors.

Andrew S. Windmueller, Fidelity's director of institutional fixed income, said the team-based fixed-income approach, which looks to consistently squeeze a few basis points of alpha from Fidelity's strong credit operations to its trading desk as well as other sources, gives the company the capacity to go head-to-head with the top-tier bond managers.

Some of Fidelity's current institutional fixed-income clients don't find that idea outlandish.

Ron Schmitz, director of investments for the $46 billion Oregon Public Employees Retirement Fund, Salem, said Fidelity has proven it can "play with the big boys." Oregon, which hired Fidelity as a bond manager four years ago, has $2.31 billion with the firm in an active core plus strategy.

Anthony Johnson, chief investment officer with the $4.1 billion Philadelphia Public Employees Retirement System, is another satisfied customer. Philadelphia hired Fidelity just over a year ago, and its $145 million core plus portfolio has consistently outperformed the benchmark, the Lehman Aggregate plus 60 basis points, he said. Performance has been very good and Fidelity's client service has been stellar, he said.

Mr. Lawton said inflows in Fidelity's investment-grade fixed-income operation accounted for a big chunk of the roughly $20 billion in net inflows that helped grow FMT's assets under management from $60 billion at the end of 2002 to more than $100 billion today, he said.

Fidelity's Mr. Beyerl said the company has won 46 new investment-grade fixed-income mandates, totaling $3.9 billion, from defined benefit plans since the end of 2002, more than doubling the amount of assets Fidelity manages in that strategy to $7.9 billion.

In bond mutual funds, Fidelity has recovered its reputation as a top-flight manager after some aggressively managed funds suffered sharp losses in the mid-1990s. A revamped Fidelity has kept risk under control and "delivered really impressive results over the last five-plus years," said Scott Berry, a Detroit-based analyst with fund research giant Morningstar Inc., Chicago.

"We're big fans of Fidelity's bond shop. … We would put them up against almost anybody," said Mr. Berry. He pointed to funds such as the Fidelity Government Income Fund, with more than $4.5 billion in assets, which has bested its benchmark by 98 basis points a year over three years and 77 basis points a year over five years. Another winner is the Fidelity Investment Grade Bond Fund, with $6.5 billion in assets, which has outperformed its benchmark by 73 basis points and 64 basis points a year on three- and five-year periods, respectively, according to Morningstar.

But Fidelity's overpowering brand name hasn't always helped. Thomas J. Silvia, senior vice president and bond group leader, said in earlier years it took some effort to get consultants and institutional clients beyond the idea that Fidelity is an equity-focused mutual fund company.

Plus, Fidelity's plan announced in March to build out a separate institutional money management unit has left clients in equity strategies run by portfolio managers who also look after mutual funds worried about the prospect of being moved to new managers in the coming years. But that concern shouldn't affect fixed-income clients, Mr. Lawton said.

The plans for a separate institutional unit are focused on domestic equity and will have "no impact on fixed income," where "economies of scale work in our favor," Mr. Lawton said. Fidelity's institutional fixed-income operation has built up a "fair amount of momentum," and portfolio managers who run both retail and institutional fixed-income money now will continue to do so, he said.

Grail Partners' Mr. Putnam applauded that decision: "In the fixed-income business, size begets alpha," unlike equities, where carving up operations into smaller businesses makes sense, he said.

Fidelity's institutional clients are positioned on both sides.

"We're not uncomfortable with the direction they're going in," said Perrin Lim, senior investment officer, fixed income, at Oregon PERF. "As long as a year from now they don't end up with a billion dollars in extra money under 200 separate mandates," there shouldn't be a problem, he said.

But an executive with another public fund, who declined to be named, said he doubts Fidelity's decision to structure its equity and fixed-income businesses differently can or should be a permanent one.

For now, observers say Fidelity's fixed-income business is advancing, but over very difficult terrain.

The biggest obstacle Fidelity has is that "guys we have been using for years" — such as WAMCO and BlackRock — "continue to meet and exceed expectations," said John Lake, head of fixed-income manager research with Summit Strategies, a St. Louis-based consulting firm.

Fidelity's Mr. Lawton said he doesn't see the firm's prospects relying on a competitor stumbling. With Fidelity's approach providing a good balance to the more macro-oriented strategies of a PIMCO, for example, his shop should continue to gain momentum during the coming years, he said.