Should you trust Fidelity's advertising? » PRINT

By Paul Merriman

Fidelity Investments is the largest mutual fund company, managing hundreds of funds for tens of millions of U.S. investors. But Paul Merriman believes Fidelity's advertisements are deliberately misleading. In this article, Paul shows how to separate the substance from the fluff.

One of the best tools you have as an investor is built-in and free: your brain. Use it, and you can be a successful investor. Let somebody else use it, and you are asking for trouble.

If you ever need that brain to be sharp and handy, it's when you read advertisements for mutual funds. If you approach these ads with the proverbial open mind that is supposed to be a good thing, you may be easily persuaded to think the way the marketing people want you to think. That can be harmful to your financial health.

Imagine you're in the market for a new car. You see an ad showing a brand-new model surrounded by the factory workers who have just built it. Their smiling faces tell you how proud they are, and you're supposed to get a warm fuzzy feeling about that car.

Because you're reading this article, I'm pretty sure you are smart enough not to fall for that when you're shopping for a vehicle. If the car breaks down, isn't comfortable, won't fit in your garage, burns too much gas or makes your spouse gag to look at it, the image of those smiling faces will fade pretty fast. In a contest between substance and fluff, you know which one should be the winner.

It's easy to see this in a product you understand like a vehicle. But can you spot the equally fluffy and meaningless pitches for financial products?

One of the big challenges investors face is Wall Street's constant barrage of information that looks or seems much better than it really is. I'm talking about statements that may be factually correct but are still misleading. I recently ran into a blatant example of this from Fidelity Investments. Though Fidelity is an excellent mutual fund company, I hope you'll hold onto your wallet when you read their advertisements!

In Newsweek, Fidelity's two-page ad says: "Our funds are no-load, direct to you - and managed by some of the most experienced professionals in the business. Maybe that's why we offer you more 4- and 5-star funds than anyone else."

OK, turn on your brain and let's look at what is true here.

It's true that Fidelity's funds are no-load and managed by some of the most experienced professionals in the business. (The same thing could be said for a lot of its competitors.) It's also true that Fidelity has more funds with Morningstar's four-star and five-star ratings than any other fund company.

If you re-read the quote from that ad, you'll see that Fidelity doesn't come right out and say that the first fact (no loads, experienced managers) is the cause of the second fact (larger numbers of high-rated funds).

Fidelity can't do that because the Securities and Exchange Commission won't let the company make false claims. And this would certainly be a difficult claim for Fidelity to substantiate. The advertisement gets around this in a tricky way by using the word "maybe." That's a very interesting word in this case.

If you can't say something, you can suggest it, hoping that your reader's brain is in "pause" mode and that said reader will conclude something that Fidelity knows isn't really true.

Fidelity may think the use of "maybe" is pretty clever marketing. But I think it shows how little respect Fidelity has for its audience. Fidelity hopes you aren't smart enough to see through this misleading ploy. I hope you are.

Is "misleading" too harsh a term for me to use? You be the judge.

Here's an analogy. Imagine you're a parent trying to decide where to move, and the choice comes down to which of two high schools you want your teenagers to attend. One is a big-city school, the other a much smaller one 30 miles away.

Now imagine the principal of the big-city school bragging about its experienced, dedicated teachers and saying: "Maybe that's why we have so many more National Merit scholars" than the small-town school.

There's that word "maybe" again, and I hope it puts your brain on high-level alert. I think the word "maybe" is a ruse designed to send your brain on a detour away from all the facts.

If the big school had 1,200 students and the small school had only 200, there certainly should be more top scholars coming out of the bigger school. It doesn't have anything to do with the quality of the teachers. It's because the big school has six times as many students to start with. (The big school probably has many more failing students, too!)

Back to Fidelity funds. The reason it has so many four-star and five-star funds is because it has so many funds to start with.

I counted 140 unique diversified and sector equity funds in the quarterly mutual fund section of the New York Times, excluding funds with the same portfolio and manager but with different commission structures. That's far more funds than any other fund company.

Fidelity's ad was telling the truth. Based on three-year returns, the company has 55 four-star and five-star funds, as rated by Morningstar. If a fund has four or five stars, that means its performance was in the top 32.5 percent among all funds in its asset class. (Five stars means the top 10 percent, four stars the next 22.5 percent.)

Fidelity can legitimately claim 39.3 percent of its funds were in the top two Morningstar tiers, roughly the top third of their peers.

Vanguard, which has index funds we recommend all the time, has 53 unique diversified and sector equity funds. Of these, 34, or 64 percent, have four-star or five-star ratings at Morningstar. One of those funds is rated two stars, and the other 18 are rated three stars.

Out of curiosity, I decided to run a similar analysis of the 23 Dimensional Fund Advisors equity funds. Dimensional is the best mutual fund family I know of, and we use these funds in managing money for clients. I found that 19 of those 23 Dimensional funds, or 82.6 percent of the total, had Morningstar ratings of four or five stars.

Score: Dimensional 82 percent, Vanguard 64 percent, Fidelity 39 percent.

The great majority of Dimensional funds were in the top third of their peer groups, compared with only about two out of five at Fidelity and nearly two-thirds at Vanguard.

Remember the analogy of the failing students at the big high school?

When I looked at Fidelity's fund lineup, I found 46 funds (or 32.8 percent of its 140) ranked either one or two stars by Morningstar. That means nearly one of every three Fidelity funds ranked in the bottom third of their peers.

I don't dispute Fidelity's claim that it has highly experienced managers. I'd just remind you that those managers were at the helm of the 46 low-rated funds as well. But Fidelity neglected to mention that in its advertisement.

Do star ratings really matter in the first place? Fidelity's marketing department seems to think so. But I believe that what really matters to investors is results. Savvy investors should use their brains to determine where superior results come from. In my opinion, that is the core of being a successful investor.

Do investment results depend on hiring excellent managers? I don't think so. Most funds are run by quite talented managers. Do investment results depend on Morningstar star ratings? We shall see shortly.

Personally, I think superior investment results come from being invested in the right asset classes.

In 2005, many investors experienced the stock market as being a go-nowhere place. The Standard & Poor's 500 Index was up 4.9 percent, the Nasdaq advanced 1.4 percent and the Wilshire 5000 gained 4.6 percent.

But investors were likely to do much better than that if they had a proper mix of international stocks as well as those from the U.S., value stocks as well as growth stocks and small-cap stocks as well as large-cap ones.

At the start of 2005, we told investors how to find the best access to each of what we believe are the most important asset classes, whether their accounts are at Fidelity, Vanguard, Schwab or T. Rowe Price. (This advice is always available free online at www.FundAdvice.com.) Investors who took that advice at the start of 2005 had plenty of reason to be glad that they did.

Accompanying this article, Figure 1 shows our fund recommendations at Fidelity, Schwab, T. Rowe Price and Vanguard. For each fund, we show its Morningstar star rating. In Figure 2, you'll see how much of each portfolio is made up of five-star funds, four-star funds, three-star funds and so on. And you'll see the 2005 performance for each portfolio.

Click here to see those figures.

These are not portfolios we manage for clients. The table shows what investors can do on their own. I'm guessing that most do-it-yourself investors wish they had achieved returns like these in 2005.

I have not shown the performance for each fund (you can look it up online at Morningstar.com if you're interested) because focusing on individual funds takes investors' eyes off the ball. What matters is the portfolio, not the individual pieces that make it up.

Fidelity's fund lineup in this portfolio is handicapped by the fact that there's no international value fund and no international small-cap fund of any kind. Still, last year this group of funds, when weighted as indicated, returned 14.4 percent.

(In August 2005, Fidelity began offering the International Small Cap Opportunities Fund (FSCOX), which is now part of our Fidelity suggested portfolio. However, that fund's returns could not be included in our calculations because it was not in operation for the full year.)

Fidelity's ad focused on star ratings, but as Figure 2 shows, the majority of this very successful portfolio was made of funds rated three stars or less (or in the case of the Small Cap Value fund, no rating because the fund doesn't have enough history).

The T. Rowe Price portfolio had even better performance with nearly two-thirds of its money in three-star funds. The Vanguard portfolio, the only one with a majority stake in high-ranked funds, was third among this group for 2005 performance, while the Schwab portfolio - the only one with a five-star fund - was in last place.

My conclusion: I find it hard to see any compelling connection between last year's returns and the number of stars in the funds.

You may wonder why the T. Rowe Price portfolio did so much better last year than the Vanguard one. Most of the difference came on the international side. T. Rowe Price's International Discovery Fund, which invests in small-cap international stocks, was up 27.9 percent last year. Vanguard, unfortunately, does not have an international small-cap fund that's open to new investors.

The point is not that T. Rowe Price has better funds or better managers. The point is that T. Rowe Price gave investors access to an asset class they couldn't get at Vanguard.

Another interesting aspect of these four diversified portfolios helps explain why they did so much better than the U.S. market averages. Each one has 10 percent allocated to emerging markets stocks. A 10-percent slice of a portfolio goes a long way when those funds return 44.3 percent (Fidelity), 36 percent (Schwab), 38.8 percent (T. Rowe Price) or 32.1 percent (Vanguard).

Fidelity's marketing department would have you believe investors need many funds with high star ratings - because that is what Fidelity offers.

But if you'll take the time to think critically, it's easy to realize that Fidelity's marketing department is not in business to make you a better investor. No, its job is to generate business for Fidelity, thus benefiting the company and its shareholders.

My job is to make you a better investor. If you spend more time using your brains and if you adopt a properly diversified portfolio, I've done my job. And if I've done my job, I believe you will benefit.

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