Fidelity Magellan Fund

Kingswell's 2025 retrospective on Lynch dwelt on his decision to retire from Magellan at age 46, when the fund had grown from a $20 million afterthought to a $14 billion colossus. Lynch's stated reason was family: he had been working six-day weeks since 1977, his children were growing up, and his wife Carolyn had been carrying the household through his career. The decision was unusual because Lynch was at the peak of his returns, not because he had lost his touch. He turned the keys over to Morris Smith and walked away from the public markets at a point where most successful managers would have ridden the franchise for another decade. The deeper point of the retirement, in Lynch's own telling, was that fund management at the scale Magellan had reached was no longer the job he had signed up for. The early Magellan — small, obscure, with a portfolio of a few dozen names — had allowed Lynch to do the primary research he loved. The $14 billion Magellan required managing flows, monitoring a thousand positions, and explaining quarterly performance to consultants. The work had become administrative rather than analytical. Lynch's retirement was a decision to leave a job that had evolved away from the work that had produced the record. Lynch's post-retirement career at Fidelity has been as a vice-chairman, mentor, and philanthropist. He has continued to write, to advise younger analysts, and to fund medical research and Catholic education through the Lynch Foundation. The decision to retire from Magellan has held up as a model of succession planning — Smith and his successors preserved the Magellan culture for years after Lynch's departure, before the fund's scale eventually made the Lynch-style returns structurally difficult. Lynch's retirement is the rare case of an investor leaving at the top and not looking back.

Kingswell's interview returned to Lynch's view of the Magellan record itself, and to the question of how much of the outperformance was skill and how much was circumstance. Lynch's own answer was that the Magellan years were the conjunction of a particular fund, a particular market structure, and a particular research method that has not been replicable since. The fund was small enough in its early years that Lynch could take meaningful positions in small companies without moving the price; the market structure of the late 1970s and early 1980s had thin sell-side coverage of small-caps, which left Lynch's scuttlebutt method with a wide-open opportunity set; and the research method — primary visits, competitor interviews, retail-store observation — was a discipline that few institutional desks were applying. Lynch was candid that the same method, applied to the much larger Magellan of the late 1980s, would have produced a smaller edge because the small-cap names could no longer move the portfolio. The $14 billion Magellan was structurally forced into large-cap names whose coverage was already crowded, and the Lynch-style returns were no longer available at that scale. The implication Lynch drew was not that his method had stopped working in the small-cap segment, but that the Magellan franchise had outgrown the segment where the method produced its edge. The honest conclusion is that the Magellan record was, in part, the product of running a small fund in a small-cap market — conditions that the post-retirement Magellan could not reproduce. The retrospective closed with Lynch's observation that the most durable lesson of the Magellan record is not the specific returns but the methodological discipline. Primary research, a long measurement window, asymmetric position sizing, and a refusal to bet on macro forecasts remain the core ingredients. Any investor applying the method to the small-cap segment today should, in Lynch's view, still find an edge — provided they are willing to do the unglamorous primary work that the institutional desk has abandoned.

Wikipedia's overview of Peter Lynch's career is the document in which the published record of Lynch's career is most directly accessible to the general reader, and the document is the starting point for the investor who is encountering Lynch's record for the first time. The overview records Lynch's path from a Boston College undergraduate caddy gig at Brae Burn Country Club, where he met Fidelity's president, through a Wharton MBA, an artillery tour in Korea, and a research-analyst role at Fidelity in 1969. The path matters because Lynch's edge at Magellan was built on the research discipline he learned as an analyst, not on a stock-picking intuition he possessed and others did not. The overview is, in this sense, the document that grounds the Magellan record in the disciplined practice of the analytical career, and the document on which the investor's further study of Lynch's working method should rest. The overview's most instructive passage is its record of the Magellan returns. Lynch managed the Magellan Fund from 1977 to 1990, and the fund's annualized return over the period was approximately twenty-nine percent, more than double the S&P 500's annualized return over the same period. The fund's assets under management grew from approximately twenty million dollars when Lynch took the helm to over fourteen billion dollars when he stepped down. The overview is candid that the returns were the cumulative result of the disciplined practice of the everyday observation, the shoe-leather research, and the long holding period, and that the returns were not the result of a stock-picking intuition Lynch possessed and others did not. The overview is, in this sense, the document that grounds the Magellan record in the disciplined practice of the analytical career, and the document on which the investor who would study Lynch's record should proceed to the primary sources Lynch himself wrote. The overview's most practical instruction to the investor who would study Lynch's record is that the Magellan returns are reproducible only by the investor who is willing to apply the disciplined practice Lynch applied. The disciplined practice is available to anyone who is willing to do the work, and the work is the disciplined practice of the everyday observation, the shoe-leather research, the financial-statement work, and the long holding period. The overview is, in this sense, the document on which the investor who would study Lynch's record should begin, and the document from which the investor should proceed to the primary sources Lynch himself wrote. The Wikipedia overview is, in this sense, the starting point for the investor who is encountering Lynch's record for the first time, and the document on which the investor's further study of Lynch's record should rest.

Lynch's experience of the October 1987 crash is one of the most retold episodes in his public commentary, in part because he was on a golf course in Ireland when the market lost twenty-two percent in a single session. By the time he could reach a phone and understand what had happened to his portfolio, Magellan had dropped from roughly twelve billion dollars to roughly eight billion. The episode is often cited as a lesson in the futility of attempting to time the market — Lynch, despite being one of the most plugged-in investors in the world, did not see the crash coming and could not have acted on it if he had. Lynch's retrospective on the crash emphasised two lessons. First, the volatility of an equity portfolio is the cost of capturing the equity premium; the investor who cannot tolerate the cost cannot capture the premium. Magellan recovered from the 1987 crash within two years and went on to compound substantially through 1990. The investors who sold on October 19 or 20 of 1987 locked in their losses and missed the recovery. Second, the crash exposed which positions had been bought on leverage or on margin — those were the positions that had to be liquidated into the falling market, while the unleveraged positions could be held and ultimately recovered. The deeper methodological lesson Lynch drew was that the holder of unleveraged equity in fundamentally sound businesses does not need to forecast crashes. The investor whose positions are sized so that no single drawdown forces a sale, and whose businesses are sound enough to recover their earnings power after a macro shock, can sit through crashes by default. The 1987 crash was, in Lynch's framing, less a forecastable event than a stress test of portfolio construction. The portfolios that survived were the ones whose position sizes and balance sheets allowed them to do nothing — and doing nothing was, in 1987, the action that produced the best outcome.

Lynch's response to recession worries in the post-1987 period was, characteristically, to ignore them. The 1988 Barron's Roundtable produced a list of twenty-one picks that Lynch had selected on bottom-up analysis, without taking a view on whether the U.S. economy was entering recession. His argument was that recessions are visible only in retrospect, that the equity market had already discounted the recession if it was coming, and that the investor who waited for the recession to be confirmed would miss the recovery. The Magellan portfolio was, in the post-crash period, a portfolio of businesses whose earnings would survive a recession and whose prices had been marked down to levels that already reflected recession risk. Lynch's argument against recession-timing was arithmetic. The U.S. economy had been in recession roughly one year in five over the post-war period. An investor who moved to cash ahead of every feared recession would have been right about one in three of those fears and would have sat out two-thirds of the recoveries. The arithmetic of being out of the market during recoveries — which tend to be concentrated in the first months after the recession ends — overwhelms the arithmetic of avoiding the recession itself. Lynch's view was that the recession-forecaster has to be right about both the timing of the recession and the timing of the recovery, and that the compound probability of being right on both is too low to justify the strategy. The 1988 picks list was, in retrospect, a reasonable portfolio of consumer and industrial names that compounded through the late-1980s expansion. Lynch's framing of the picks was that the businesses were growing earnings at rates that would carry the share prices higher over a three-to-five-year horizon, and that the macroeconomic path over that horizon was not the variable that determined the return. The discipline of looking through the macro noise to the underlying business is the discipline that the 1988 list illustrated, and the discipline that Lynch believed had produced the bulk of Magellan's outperformance over the prior decade.

Despite that philosophy and despite my callow words to Forbes, within a year we took our first aggressive steps to expand our technology commitment. Bob DiStefano—then and now Vanguard’s technology boss, and for my money, one of the most capable technology executives in the financial services field—reminds me that in mid-1986 I urged him to step a bit more lightly on our cost-control brake and more heavily on the accelerator that drove our then-modest technology program. While the numbers seem puny by today’s standards, we quickly upped the number of programmers’ two-and-a-half fold—from 22 to 56—and our total tech staff to 75. We have been building our technology focus and commitment ever since. In those days, our world was fairly simple: each shareholder in each fund got a regular quarterly statement from each fund independently, just as if he or she owned, say, one Vanguard fund, one Fidelity fund, and one T. Rowe Price fund. With some 700,000 shareholders on our books—most of who owned but a single fund—that was “industry standard” at the time. But the standard was about to change, and our commitment to expand our technology effort came not a moment too soon. Our business not only grew by leaps and bounds, but at ever-increasing levels of activity and complexity. Today, with some eight million shareholders on our books, Vanguard has become the second largest mutual fund organization on the face of the globe.

Everywhere I go I see hope in our youth—you!—and a spirit of idealism, too. Yes, business is about creativity and productivity, and goods and services and jobs and benefits, and success and wealth and greatness—all of these. But business must also be about ideals, about making the world a better place. You’ve spent two years here studying business, and have been inculcated in the belief that markets work. They do! And that economics is, finally, the language of business. It is! But without virtue, business is a hollow pursuit. In his remarkable book, Business as a Calling, the inspiration for the title of my remarks today, the theologian Michael Novak catalogues three cardinal virtues of business:  “The virtue of creativity . . . the inclination to notice what other people don’t yet see, to act on insight . . . to foresee the needs of others and satisfy those needs . . . intellectual capital is the chief source of wealth.  “The virtue of building community . . . the wealth of all nations . . . more than ever, work toward a common goal is work with others and work for others . . . requiring fidelity, reliability, diligence, industriousness, and especially courage.

Market Share and Client Loyalty The very first sentence in the 1994 Harvard Business Review article, “Putting The Service-Profit Chain to Work,” noted, “outstanding service organizations spend little time setting profit goals or focusing on market share.” Nor do we. From the time Vanguard began, my two fundamental rules were: “1) Market share is a measure and not an objective; and 2) Market share must be earned and not bought.” Nonetheless, Vanguard’s market share has grown. And grown. And grown. From 9% of direct marketing assets in 1980, we topped 10% in 1984, 15% in 1988, 20% in 1992, and 25% in 1998, reaching a 29% share in late 1999 (Chart 3). Since 1986, significant market share growth has been achieved by just two firms: Vanguard (+14 percentage points, from 15% to 29%) and Fidelity (28% to 31%, +3 points). In the meanwhile, T. Rowe Price (-3 points, to 5%), Scudder (-3 points, to 2%), and Dreyfus (-14 points to 2%) all tumbled sharply. With a total share of 72% in 1986 and 70% in 1999, the “Big 5” are clearly swapping shares with one another. In fact, of the 25 largest firms in the direct marketing field, 19 have lost market share since 1986, with only six gaining. What can we learn from the success of the two peerless leaders in gathering market share? Only this: There is no single route to success.performance

2 Among the firms named as providing assistance and perspective for the study: Fidelity, Putnam, Mellon, State Street, Oppenheimer, Citigroup, and Massachusetts Financial Services. I hope that you will pardon me if I wonder how carefully they considered its sweeping implications.

The author also lauds Vanguard for having “a real and tangible sense of purpose.” However, he points out that my initial vision was a blurry one, and concludes that the public version of our founding is to a degree a myth—albeit “a good one.” But in all, I pass his first test: “Bogle has realized his dream.” “Second, the will to conquer, the impulse to fight, to succeed for the sake, not of the fruits of success, but of success itself.” The Schumpeterian phrase is used in the paper to discuss how I faced a bad situation, by dint, in the author’s words, of “sheer force of will.” But he notes, that without these external circumstances, there is a question as to whether that internal will would have had the opportunity to function. He concludes, doubtless correctly, that “were he not forced to act out of the ordinary, he would not have acted out of the ordinary. . . . because his conservative nature (I’m sure that’s accurate) ensured that his entrepreneurial passions would remain largely checked until circumstances called for their release.” He also believes that my motivations were “not so purely altruistic as the Vanguard myth would suggest.” Fair enough. He also describes me as a fighter, noting that “the fight first to secure Vanguard’s independence and then to see it triumph has been the story of Bogle’s life since 1974.” Further, he refers to the state of war that is said to exist between Vanguard and Fidelity.

and done, an advantage of nine percentage points. The message: Sweet selling is sour stewardship. The counterproductive result of this business of over-marketing and promotional hype is that the returns actually earned by mutual fund investors are even worse than the inferior returns shown in my earlier study. How much worse? Don’t take my word for it. Look at the figures reported by the fund industry’s largest firm:2 With the S&P 500 providing an annual return of +16.3% since 1984 and the average fund earning 13.1%, the return earned by the average mutual fund investor was just +5.3%(!) Nearly 40% of the fund return vanishes into thin air when we take into account where investors actually placed their money. It turns out that fund investors earned not 80% of the stock market’s annual return, but 33%. And not 60% of the market’s cumulative wealth, but 12%, because the $120,000 profit earned by simply owing the market compared with but $14,000 for the average fund investor. Is the mutual fund industry meeting the needs of individual investors? You tell me. 2 Source: Fidelity. -$60 -$40 -$20 $0 $20 $40 $60 $80 $100 Q1'99 Q2'99 Q3'99 Q4'99 Q1'00 Value Funds Growth Funds Period Total Growth: $238 Value: ($29) When Marketing Replaces Stewardship: Net Cash Flow into Growth and Value Funds (in billions) 0% 50% 100% Annual Return Profit on $10,000 Investment S&P 500 Avg. Equity Fund Investor Average Equity Fund Investor vs. The Stock Market Total Returns, 1984 - 2000 16.3% 5.33%

costs incurred by those who would help investors to beat the market themselves constitute the reason that investment managers as a group are destined to fail at the task. Why? It is only to state the obvious when I point out that all investors as a group must of necessity earn the market returns—but only before the costs of investing are deducted. After these costs are taken into account—after all of the fees, the transaction costs, the distribution costs, the marketing costs, the operating costs, and the hidden costs of financial intermediation—investors must—and will—incur a loss, indeed a loss precisely equal to the aggregate amount of those costs. Beating the market before costs is a zero-sum game; beating the market after costs is a loser’s game. Management of Embedded Alpha At long last, this reality has taken root, even among financial market participants who are not among the lowest-cost players in the game. Consider the paper entitled Success in Investment Management: Building the Complete Firm, prepared two years ago by Merrill Lynch and BARRA Strategic Consulting Group after consultation with a distinguished list of money managers that included Fidelity, Putnam, and Citigroup. The study reached this major conclusion: Management of Embedded Alpha, the frictional costs of running a portfolio, will emerge as an essential contributor to investment performance. (It’s about time!)

Mutual Funds as Proxy Voters A new development may well inspire mutual funds to join those investors to become more conscious of their responsibilities of corporate citizenship, and to take their voting responsibilities more seriously. Early in 2003, the Securities & Exchange Commission approved a requirement that funds (the “agents”) report to their owners (the “principals”) how their (the owners’) shares were voted in corporate proxies. While such disclosure would seem totally logical, the fund industry brought out its biggest guns to battle the proposal, and even long-time rivals Fidelity and Vanguard joined together in expressing their opposition in a Wall Street Journal op-ed piece signed by their chairmen. (“Politics makes strange bedfellows.”) Despite the opposition, the SEC stood its ground, and in August we’ll learn how each mutual fund voted each of its corporate proxies during the 2004 season. It’s about time, and it will matter. For I believe that the requirement to disclose proxy votes will begin the process of giving mutual funds the motivation to become better corporate citizens. For example, The Vanguard Group, which has traditionally regarded regular voting of proxies as a fiduciary duty, adopted more aggressive proxy voting guidelines in 2003. While the funds had previously endorsed 90% of director slates, last year they ratified all directors in only 29% of the slates, withholding votes from at least one nominee in a stunning 71% of the cases.

funds, on the way to topping 50%. Indexing is an idea whose time has finally come, a disruptive innovation that places the interests of investors ahead of the interests of fund managers. Early Signs of Progress We have a long way to go before corporate governance participation by active money managers and passive index funds reaches full fruition. But the tide is moving strongly in that direction. One encouraging sign is the “Commonsense Corporate Governance Principles,” an open letter from a group of major institutional managers that calls for a focus on “long-term value creation.” Its set of governance principles was developed by a group of giant index fund managers (Vanguard, BlackRock, and State Street) and active money managers with a strong tendency to invest for the long term (including American Funds and T. Rowe Price). Another encouraging sign of greater participation in corporate governance (especially to yours truly!) is the evolution of Vanguard, now the world’s largest index fund manager ($3 trillion) and second largest money manager ($4.5 trillion). The turnaround in the firm’s philosophy has been dramatic. In 2003, Vanguard joined Fidelity in a major public statement opposing even the disclosure of its proxy votes at corporate annual meetings. But by 2012, Vanguard was actively engaging with the managers of its portfolio holdings. Then in 2017, Vanguard came full circle, providing its first formal annual report on “Investment Stewardship.

Changes in Mutual Fund Leadership: Then and Now Rank 1951 Fund Name Total Assets* (Millions) 2015 Manager Name Total Assets (Billions) 1 M.I.T. $472 Vanguard $2,988 2 Investors Mutual 365 Fidelity 1,615 3 Keystone Funds 213 BlackRock 1,230 4 Tri-Continental 209 American Funds 1,216 5 Affiliated Funds 209 JPMorgan Funds 519 6 Wellington Fund 194 State Street Global 497 7 Dividend Shares 186 T Rowe Price 493 8 Fundamental Investors 179 Franklin Templeton 480 9 State Street Investment 106 PIMCO 375 10 Boston Fund 106 Federated 272 Total $2,239 Total $9,686 Percentage of Industry 72% Percentage of Industry 57% Total industry assets: $3.1 billion. Total industry assets: $16.9 trillion *Includes associated funds. ** ** ** ** No longer in business. ***New leaders. *** *** *** *** *** THE NUMBER OF FUNDS EXPLODES . . .

Number of Funds—1951 & Today Original Name Total Assets (Millions) No. of Funds Managed Current Name Total Assets (Billions) No. of Funds Managed M.I.T. $472 2 MFS $180 78 Investors Mutual 365 3 Columbia 165 116 Affiliated 209 3 Lord Abbett 108 37 Wellington 194 1 Vanguard 2,988 140 Eaton & Howard 90 2 Eaton Vance 101 130 Fidelity 64 1 Fidelity 1,615 321 Putnam 52 1 Putnam 81 77 American 27 2 American 1216 35 T. Rowe Price 1 1 T. Rowe Price 493 116 Dreyfus 0.8 1 Dreyfus 248 151 Total/Average $1,475 1.7 Total/Average $7,195 120 2014 1951 Major Mutual Fund Groups

Rank Fund Name Total Assets* (million) Notable Smaller Funds Total Assets* (million) 1 M.I.T. $472 Eaton & Howard $90 2 Investors Mutual 365 National Securities 85 3 Keystone Funds 213 United Funds 71 4 Tri-Continental 209 Fidelity 64 5 Affiliated Funds 209 Group Securities 60 6 Wellington Fund 194 Putnam 52 7 Dividend Shares 186 Scudder Stevens & Clark 39 8 Fundamental Investors 179 American 26 9 State Street Investment 106 Franklin 25 10 Boston Fund 106 Loomis Sayles 23 T. Rowe Price 1 Dreyfus 0.8 Total $2,239 Total $537 Percentage of Industry** 72% Percentage of Industry 17% *Includes associated funds. **Total industry assets: $3.1 billion. Mutual Fund Industry Assets, 1951 2. “Big Money in Boston”—1951 Percentage of Mutual Fund Assets Managed* Boston 46% New York 27% Minneapolis 13% Philadelphia 7% Other 7% 3. *By location of firm headquarters.

the principal function of investment companies is the management of [their]investment portfolios. Everything else is incidental . . . The principal role of the mutual fund should be to serve its shareholders. What should one make of these words? An intelligent design for the new structure of fund management that was created when I founded Vanguard in 1974? The idealistic ruminations of an immature and inexperienced college senior? Something in between? I’ll let you decide. But all through my career I have talked that talk, and through Vanguard, walked that walk, focusing on serving all of those honest-to-God, down-to-earth, individual human beings who have entrusted us to manage their 2 A sort-of catty aside. (Sorry ‘bout that!) Our tacit rival, Fidelity, has felt the pain. Some 50 percent larger than Vanguard at the turn of the century—by $250 billion—Fidelity now lags Vanguard by $650 billion. (Despite all of those intrusive and expensive “green path” commercials.)

(Fidelity once managed just a single fund; the firm now manages 294 funds. Similarly, Vanguard also began the period with a single fund, and is now responsible for 140 funds. One can only trust that each member of the board of directors—in both cases—takes seriously his or her fiduciary duty to know and to understand each one of the scores of funds under the board’s aegis.)

Number of Funds—1951 & Today 8. Original Name Total Assets (million) No. of Funds Managed Current Name Total Assets (billion) No. of Funds Managed M.I.T. $472 2 MFS $128 80 Investors Mutual 365 3 Columbia 162 116 Affiliated 209 3 Lord Abbett 97 38 Wellington 194 1 Vanguard 2,136 140 Eaton & Howard 90 2 Eaton Vance 107 139 Fidelity 64 1 Fidelity 1,372 294 Putnam 52 1 Putnam 59 76 American 27 2 American 994 33 T. Rowe Price 1 1 T. Rowe Price 375 106 Dreyfus 0.8 1 Dreyfus 228 152 Total/Average $1,475 1.7 Total/Average $5,658 117 2013 1951 Major Mutual Fund Groups Note: 12 of today’s 20 largest firms did not exist (or did not manage mutual funds) in 1951, including BlackRock, PIMCO, State Street Global, and JP Morgan With the rise of all of that product proliferation, the fund industry has come to suffer a rate of fund failures without precedent. Back in the 1960s, about 1 percent of funds disappeared each year, about 10 percent over the decade. By 2001-2012, however, the failure rate of funds had soared seven-fold, to 7 percent per year, during that entire period, 90 percent. With about 6,500 mutual funds, 5,500 have been liquidated or merged in other funds, almost always into members of the same fund family (with more imposing past records!) Assuming (as I do) that such a failure rate will persist over the coming decade, some 3,500 of today’s 5,000 equity funds will no longer exist—the death of more than one fund on every business day.

funds that operate under the original industry model rise by 84 percent, and the expense ratio of one fund group that operates under a new business model falls by 69 percent, it is at least possible that there’s a message there. Mutual Fund Expense Ratios 1951 & 2013 Percent of Assets Percent Change +220% +121% +108% +98% +65% +62% +53% +17% +84% -69% 0.42 0.56 0.64 0.66 0.63 0.50 0.75 0.84 0.62 0.55 1.33 1.23 1.32 1.31 1.04 0.81 1.14 0.98 1.15 0.17 0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 MIT/MFS (c) Investors Mutual/Columbia (c) Eaton Howard/Eaton Vance (sh) Putnam (c) Fidelity (p) T. Rowe Price (sh) Affiliated/Lord Abbett (p) American (p) Average (ex. Vanguard) Wellington/Vanguard (m) Ownership Type: (c) conglomerate; (sh) public shareholders; (p) private; (m) mutual 9. The data in the chart are comprised of fund expense ratios unweighted by assets. While weighted ratios can only be approximated, one can conclude that the aggregate fees paid to these eight firms rose from $58 million in 1951 (measured in 2012 dollars) to $26 billion in 2013— more than a four-hundred fold jump in the cost of fund management. One might have hoped that all those dollars available to improve the quality of stock selection and investment strategy would have improved the returns earned by fund shareholders. Alas, there is no “brute evidence” whatsoever that such is the case. None. 4. The Conglomeratization of the Fund Industry April 7, 1958—A Date that will Live in Infamy.

Ownership of 50 Largest Mutual Fund Management Companies, 2012 Manager Owned (9) plus Mutual (1) Publicly Owned Conglomerate Total Firms with Public Ownership: 40 10. Despite the far-reaching consequences of its unfortunate birth, “conglomeratization” has been the least recognized of all of the changes that have beset the mutual fund industry. Financial conglomerates now own about two-thirds of the major fund management companies, and with the publicly-traded firms, more than 80 percent. However, for whatever one wants to make of it, each of today’s three largest fund complexes—Vanguard, Fidelity, and American Funds—has remained independent. These three firms alone manage $4 trillion, or some 30 percent of all mutual fund assets. While the private firms largely have grown organically, many of the public firms have grown by acquisition, a pattern hardly unfamiliar to the business behemoths of Corporate America. For example, The Amerprise/Columbia Funds have acquired fully a dozen previously independent fund managers. BlackRock obtained substantially all of its fund asset base through its acquisition of Barclays Global Investors in 2009, acquiring Merrill Lynch Asset Management in 2006, and its even earlier acquisition of State Street Management and Research Corporation previously owned by Met Life. (That acquisition was followed by the demise of industry pioneer State Street Investment Corporation, from my perspective a “death in the family.

(“You wouldn’t settle for an ‘average’ brain surgeon, so why would you settle for an ‘average’ mutual fund?”)11 A midwest brokerage firm flooded Wall Street with posters screaming “INDEX FUNDS ARE UN-AMERICAN. Help Stamp Out Index Funds!” Exhibit 12. 9 One could easily argue that “the date that will live in infamy” for fund managers was Vanguard’s precedent- breaking formation on September 24, 1974. For it replaced the industry’s business model with a truly mutual model that was virtually essential to the creation of our index fund. More about that later. 10 Bogle on Mutual Funds, John Wiley & Sons, 1993. 11 Fidelity’s Chairman Edward C. Johnson III doubted Fidelity would follow Vanguard’s lead. “I can’t believe,” he told the press, “that the great mass of investors are [sic] going to be satisfied with just receiving average returns. The name of the game is to be the best.” Fidelity now oversees $126 billion of index fund assets.

Wharton Magazine's 2011 profile of Lynch positioned his Magellan record in the context of his Wharton education and his Fidelity apprenticeship. The article traced Lynch's path from a Boston College undergraduate caddy gig at Brae Burn Country Club — where he met Fidelity's president — through a Wharton MBA, an artillery tour in Korea, and a research-analyst role at Fidelity in 1969. The path matters because Lynch's edge at Magellan was built on a research discipline that he learned as an analyst, not as a portfolio manager. He had spent eight years covering industries before taking the Magellan helm in 1977, and the discipline of primary company research that he applied as an analyst became the method he applied as a manager. The article highlighted Lynch's preference for companies whose products he could observe in person — Taco Bell, Pier One Imports, Dunkin' Donuts — as the visible output of a research discipline that did not stop at the financial statements. Lynch visited the stores, talked to franchisees, and watched the customer traffic before he bought the stocks. The Wharton profile made the point that Lynch's retail-level observations were not a substitute for financial analysis but a complement to it. The store visit told him whether the income statement was telling the truth about the operating reality; the 10-K told him whether the balance sheet could support the growth implied by the operating reality. The article's framing of the Magellan record was that the 29.2 percent annualised return was less a matter of stock-picking genius than of methodological discipline applied at scale. Lynch's portfolio grew to over a thousand names because his scuttlebutt produced more investable ideas than the fund could concentrate in. The diversification was a consequence of the research method, not a portfolio-construction principle. The Wharton profile argued that the post-Magellan mutual-fund industry has not produced another Lynch because the structural conditions of the 1977-1990 period — small fund, under-researched small-caps, primary-research edge — have not been replicable at the scale that today's institutional desks operate at.

The Wharton profile closed with Lynch's reflections on the Magellan record as a benchmark for the active-management industry. His argument was that the record was unusual enough that it should not be used as a standard against which to measure ordinary active managers, but typical enough in its method that the method itself remains accessible to anyone willing to apply it. The 29.2 percent annualised return was, in Lynch's view, a conjunction of skill, circumstance, and a research discipline that few other managers were applying with the same intensity. The skill and the discipline are reproducible; the circumstance — a small fund in an under-researched market segment — is not. Lynch's advice to current active managers was to look in the market segments where the institutional flow is thinnest. The Magellan edge was built in small and mid-cap consumer names that the institutional desks of the late 1970s were ignoring. The equivalent segments in 2011 — and, Lynch suggested, in any future period — are the names too small to move the benchmarks of the largest funds, too obscure to attract sell-side coverage, and too unglamorous to attract momentum capital. The active manager who screens this segment for growers with clean balance sheets and insider buying is, in Lynch's view, still applying the Magellan method to the segment where the method produces an edge. The article's closing observation was that Lynch's philanthropic activity — through the Lynch Foundation — has continued the same methodological discipline he applied to investing. The Foundation funds medical research, Catholic education, and inner-city schools with the same primary-research intensity that Lynch brought to Magellan: site visits, conversations with the people running the operations, and a focus on the operating economics rather than the headline narrative. The Wharton profile argued that the Lynch method, applied to philanthropy as to investing, produces the same kind of compounding return — slow, unglamorous, and difficult to replicate at scale.

50 largest mutual fund management complexes, only eight have maintained their original private structure—including Fidelity, Capital Group (American Funds), Dodge & Cox, and TIAA-CREF, plus Vanguard, owned by its fund shareholders. Of the remaining 41 firms on the list, nine are publicly-held (including T. Rowe Price, Eaton Vance, Franklin, and Janus) and 32 are owned by banks, giant brokerage firms, and U.S. and international conglomerates. As we shall soon see, this seemingly irresistible tide of public—largely conglomerate—ownership has ill-served mutual fund shareholders. Vanguard Goes the Other Way Only a single firm resisted this epic tide. In the context of my theme this evening, the story of its creation is a story worth telling. As you may recall, in 1960, my employer, Wellington Management Company was among the firms to ride that early wave of industry IPOs. In 1965, when I was given the responsibility of leading the firm, I recognized the challenge involved in serving those two demanding masters whose interests were so often in direct conflict. To state the obvious, we had a fiduciary duty both to our fund shareholders and to our management company shareholders as well. However, when a privately-held management company becomes publicly-held, this conflict is exacerbated. In September 1971, I went public with my concerns.

Outside ownership, in effect, demands that investment funds be viewed as products of their management companies, manufactured (in the current grotesque parlance) and distributed to earn a profit for the company. Mutual ownership, on the other hand views mutual funds, yes, mutual funds, as trust accounts, managed under the direction of prudent fiduciaries.16 It’s high time to look at the record, and compare the results achieved by the firms following these opposing philosophies. As I’m fond of saying, over our three-plus decades of our existence, Vanguard has proven to be both a commercial success and an artistic success. A commercial success, because our structure has been proven to be a superb business model. The assets we manage for investors have grown from $1.4 billion at our 1974 founding to some $1.2 trillion today. At this moment, in fact, we may well be the largest firm in our industry. (In fairness, Vanguard, American Funds, and Fidelity have gone back and forth in the lead position for several years now. Each of these giants manages about three times the fund assets of the next largest firms, Franklin Templeton and Barclays Global.) 16 I intensely dislike the use of the word “product” to describe an investment company, and, early in Vanguard’s history, banned its use at the firm.

We measured the returns achieved by the 50 largest fund complexes, defined as the firms managing at least 40 individual funds, excluding money market funds. (The complex with the largest number of funds, Fidelity, includes 471 long-term funds.) Only one of these firms managed less than about $25 billion. This remarkably representative list includes more than 8,800 funds with some $7 trillion in fund assets, 80 percent of the industry’s long-term asset base. The full study is clearly too extensive to inflict on this audience, but I’ve presented it in Appendix I as an attachment to the published version of this lecture. What I’ll now present to you (Chart 1) is a summary showing the scores of six of the top firms, the bottom six firms, and six fairly well-known firms that achieved roughly average performance records for their funds. The top-ranking fund complex, in terms of providing superior returns to its investors, was Vanguard. With 59 percent of our funds in the top group and less than 5 percent in the bottom group, the firm’s performance rating is +54.18 Joining Vanguard among the top three are DFA and TIAA-CREF, both at +50. (More than coincidentally, all three firms are focused largely on index-like strategies). At number four is T. Rowe Price (+44), followed by Janus (+38) and American Funds (+26).

Chart 1. Major Mutual Fund Managers: Fund Performance * *Morningstar ratings as of 12/2007. (Long-term funds only) Returns Highest Returns Average Returns Lowest American Funds 6 Janus 5 T Rowe Price 4 TIAA-CREF 3 DFA 2 Vanguard 1 Columbia Funds 12 AIM Inv. 11 Barclays Global 10 Fidelity 9 Morgan Stanley 8 Franklin Temp. 7 Putnam 18 ING Investments 17 John Hancock 16 MainStay Funds 15 Dreyfus 14 Goldman Sachs 13 Manager 59% 4 or 5 Stars Highest 5% 1 or 2 Stars Lowest % of Funds Ranked Major Mutual Fund Managers: Fund Performance* 54% -14 -14 -4 -3 -58 -55 -43 -40 -40 -40 Highest minus Lowest

+2), one privately-held (Fidelity -3), and three owned by conglomerates (all below par, at -4, -14, and - 14). Putting the three groups—high-performing, average-performing, and low-performing—together, it seems patently obvious that the truly mutual structure (which has only a single entrant) and the other three privately-held structures that dominate the top group have provided consistently superior returns for their shareholders, with an average score of plus 48—54 percent in the top group and only 6 percent at the bottom. This positive score stands in sharp contrast with the inferior scores that characterize the financial conglomerates at the bottom, with an average score of minus 46—13 percent in the top group and 59 percent in the one- and two-star categories. Performance Evaluations from a Higher Authority While the performance methodology I have chosen is inevitably imperfect, I believe that it is not only entirely reasonable, but a significant enhancement over most other methodologies. But, let’s not rely only on the statistics to evaluate fund performance. Let’s find out how the fund shareholders themselves regard the funds they actually own. Happily, thanks to a survey done in 2007 by Cogent Research LLC, we have measures of how fund shareholders feel about the mutual fund firms that manage their money. (The study focused on shareholders who have mutual fund investments of at least $100,000.)

Chart 2. Major Mutual Fund Managers: Fund Performance and Shareholder Loyalty 54% -14 -14 -4 -3 -58 -55 -43 -40 -40 -40 Highest minus Lowest 54% -14 -14 -4 -3 -58 -55 -43 -40 -40 -40 Highest minus Lowest Returns Highest Returns Average Returns Lowest American Funds 6 Janus 5 T Rowe Price 4 TIAA-CREF 3 DFA 2 Vanguard 1 Columbia Funds 12 AIM Inv. 11 Barclays Global 10 Fidelity 9 Morgan Stanley 8 Franklin Temp. 7 Putnam 18 ING Investments 17 John Hancock 16 MainStay Funds 15 Dreyfus 14 Goldman Sachs 13 Manager American Funds 6 Janus 5 T Rowe Price 4 TIAA-CREF 3 DFA 2 Vanguard 1 Columbia Funds 12 AIM Inv. 11 Barclays Global 10 Fidelity 9 Morgan Stanley 8 Franklin Temp. 7 Putnam 18 ING Investments 17 John Hancock 16 MainStay Funds 15 Dreyfus 14 Goldman Sachs 13 Manager -30 n/a n/a 44% -47 -48 n/a -18 -54 -11 -10 n/a -45 -32 Client Loyalty Score % of Funds Ranked

5 percent per year, five times as high? (Yes, along with Vanguard, T. Rowe Price, American Funds, and Fidelity—with costs that average 1.1 percent, somewhat below industry norms, but many times Vanguard’s costs—accounted for about one-third of all industry cash flow last year. But that still leaves two-thirds of the cash flowing largely into high-cost funds.) The fact is that there are many “signs the mutual fund marketplace may not be performing in a way one would expect in a satisfactorily functioning competitive market.” That is the opinion of the general counsel of the U.S. Securities and Exchange Commission.25 One sign, he adds, is “the law of one price,” the principle that, in an efficient, competitive market, nearly identical goods will sell at nearly identical prices. That’s obviously because with full information . . . “no rational buyer would pay more.” Yet without such price convergence in the fund field, “American investors may be being deprived of the long-term returns they deserve.” 23 “Mutual Fund Performance,” Journal of Business, January 1966, page 119. 24 “In the Vanguard,” Summer 1996. 25 Speech by Brian G. Cartwright, before the 2006 Securities Development Conference, December 4, 2006.

Affiliated Fund* Assets (million) Mgmt. Fee Rate Other Expenses Expense Ratio Mgmt. Fee Dividend Shares* Fidelity Fund Incorporated Investors* Mass. Inv. Trust Wellington Fund* Average $116 $142 0.41% 0.50 0.50 0.50 0.33 0.40 0.44% 0.31% 0.24 0.16 0.05 -0- 0.20 0.16% 0.72% 0.74 0.66 0.55 0.33 0.60 0.60% $476k 410k 215k 485k 1,200k 616k $566k Management Fee Rates and Amounts, 1950 *Now, respectively, Lord Abbett Affiliated, AllianceBernstein Growth & Income, Putnam Investors, and Vanguard Wellington 3. fund is offering a dividend yield of just 0.4 percent. Where did all the income go? It was slashed by fund expenses. The expense ratio of domestic stock funds averages 1.4 percent, reducing the funds’ gross dividend yield of 1.8 percent to 0.4 percent. Unsurprisingly, then, it appears that the average stock fund earns the stock market’s present dividend yield of 1.8 percent and then consumes fully 80 percent of that yield in fees and expenses. It didn’t need to be that way. When I began my research on this industry in 1950 for my Princeton University thesis, an interesting fact came to my attention. The first mutual fund— Massachusetts Investors Trust, founded in 1924—calculated its expenses, not on the basis of a percentage of assets, but as a percentage of its investment income. During its first 25 years, MIT charged investors the then-standard trustee fee of 5 percent of income.

We also have too many investors who are too conservative—investors who have “stable value” and money market funds as an investment option allocate nearly 24 percent to these funds. Too much! What is more, 401(k) investors are notorious for performance-chasing, and we seem not to care. Traditionally, the most popular funds in our retirement plans have been those with extraordinary past performance—but, alas, returns that are destined to revert to the market mean at best, and more likely below it. Magellan Fund, for example, was by far the most popular choice of retirement plan investors during the 1990s, but has since 1993 failed by a wide margin to achieve the average returns turned in by the unmanaged S&P 500 Index—now a thirteen-year failure, trailing the Index over that period by a cumulative total of 91 percentage points. (Amazing! Yet, Magellan remains the third most popular option.) Today’s favorites, of course, also have provided excellent past performance. (What else is new?)$100

Affiliated Fund Assets (million) Expense Ratio Dividend Shares Fidelity Fund Incorporated Inv. Mass. Inv. Trust Average $116 $140 0.72% 0.74 0.66 0.55 0.33 0.60% Growth in Assets and Expenses, 1950 - 2006 1950 $21,200 4,600 7,700 4,100 4,900 $8,500 2006 Wellington Fund $154 0.60% $45,700 Expenses (million) $0.8 0.6 0.3 0.5 1.2 $0.7 1950 $191 $79 2006 $0.9 $114 1950 2006 0.90% 1.32 0.55 1.16 1.09 1.00% 0.25% % of Div. Income 12% 10% 12% 1950 2006 44% 57% 8% 4. But a funny thing happened on the way to 2006. Those old values seemed to vanish. Remarkably, each of those six industry pioneers still exists, but, with a single exception, the idea of sharing substantial economies of scale with shareholders has gone up in smoke. (By 1969, alas, even MIT had abandoned its dividend-based fee rate in favor of the conventional asset-based fee rate. Its expense ratio subsequently more than tripled, from 0.33 percent to 1.09 percent.) Amazingly, despite the truly staggering growth in total fund assets, expenses have grown at an even faster rate, resulting in expense ratios that have actually increased. For five of these six funds, more and more of that priceless component of investment return known as dividend income was consumed by costs, (Chart 4) from 10 percent of income in 1950 to nearly 60 percent in 2006. Even as assets have increased nearly 60 times over, from $770 million to $42 billion, their expenses have increased even faster—more than 100 times over, from $3.

In 1954, MIT (now part of Massachusetts Financial Services, or MFS) lost its crown to Investors Diversified Services, (IDS) which became part of American Express, and then spun off as Ameriprise Funds, and just recently (through a merger), Columbia Funds. (No, I’m unable to rationalize how this kind of trafficking in mutual fund advisory fee contracts advances the interests of shareholders of the mutual funds involved.) IDS also wore the crown for a long time—24 years—through 1978, reaching a peak market share of 14 percent of industry assets. I’m confident that this audience knows who ultimately took that crown away from IDS.* Fidelity’s stunning ascent to industry leadership began in 1979, and it would hold that lead through 2005, a remarkable 26-year record of durability, with its market share peaking at a 13 percent share of industry assets. (You may be puzzled, as am I, why it took the financial press another four years to recognize Vanguard as Fidelity’s successor. Perhaps this oversight is explained by the fact that the firms were neck-and-neck in 2006- 07-08, with Vanguard sometimes ahead by as little as $3 billion, rounding error at these trillion-dollar levels.) In any event, Vanguard now firmly holds the undisputed crown of industry leadership. Our 13 percent market share is rapidly approaching the share level of the previous title-holders. The Vanguard-Fidelity rivalry, however, is rather complex. While our $1.468 trillion asset total exceeds Fidelity’s $1.

219 total by more than $200 billion, the assets of Vanguard’s long-term funds (stock and bond funds, excluding money market funds) of $1.3 trillion exceeds the $800 billion total of our long-time rival by fully $500 billion. This is not to say that Fidelity now plays second fiddle to Vanguard in all respects. Measured by profits, they are (I think) first in the industry and we are last. Fidelity Management and Research reported operating income last year of $2.5 billion, *There were two interlopers during this long sequence. Merrill Lynch and Dreyfus were the largest fund managers for a brief period during the late 1970s and early 1980s. In both cases, their leadership was attributable to their almost monoline dependence on money market funds, which represented 75 percent or more of their asset base.

The result has been a marked change in our society. The traditional standard of conduct in which “there are some things that one simply does not do,” took a back seat to a new standard: “if everyone else is doing it, I can do it too.” I would describe this change as a shift from moral absolutism to moral relativism. The moral themes of virtue, loyalty, fidelity, faith, and honor have been debased. Business ethics has been a major casualty of that shift in our traditional societal values, and the idea of professional standards has been lost in the shuffle. We seemed to forget that the driving force of any profession includes not only the special knowledge, skills, and standards that it demands, but the duty to serve responsibly, selflessly, and wisely, and to establish an inherently ethical relationship between professionals and the society they serve. The old notion of trusting and being trusted—which once was not only the accepted standard of business conduct, but the key to success in the marketplace—came to be seen as a quaint anachronism, a relic of an era long gone.

while The Vanguard Group, manager of the Vanguard funds, earned precisely zero. (As the only mutual mutual fund organization, all of our profits are, in substance, returned to our shareholders.) History has not been kind to those earlier monarchs of the mutual fund kingdom. The MFS market share, which peaked at 15 percent all those years ago, has now fallen below 1 percent. The IDS/Columbia market share also peaked at 15 percent and is now less than 2 percent. And Fidelity’s market share has fallen from 13 percent in 1999 to 11 percent today. What explains these declines? As I look at this history, I date the decline of MFS from 1969, when it abandoned its original unique mutual structure (similar, but not identical to Vanguard’s) in favor of private ownership of its management company. The firm was sold to Sun Life of Canada in 1982; it joined the performance-chasing game; and it saw its composite expense ratio rise from 0.19 percent to 1.20 percent, more than a six-fold rise. IDS operated during the golden age of captive sales forces, capitalized on its huge (insurance-oriented) client base, but ultimately failed to develop a strategy for a world in which giant brokerage firms and no-load funds would dominate fund marketing. As for Fidelity, I see it as a firm heavily oriented toward the superior performance of their funds (especially Magellan) during and beyond the short-lived “Go-Go Era” of the late 1960s, achieved when the firm was managing some $3.

II. The Philadelphia Society My long involvement with your CFA Society of Philadelphia, originally known as the Philadelphia Society of Security Analysts, has been only tangential in my career. But when I first entered the mutual fund industry, I observed that most of our area’s analysts were employed by bank trust departments and insurance companies. At the top of the list was Girard Trust, led by a remarkably distinguished group of investment professionals, ranging from Francis Nicholson to F.W. Elliott Farr to Frank Block—all top-grade, integrity-laden pros. Sadly, Girard is now long gone, taken over by Mellon Bank in 1983, which itself was absorbed by Citizens Bank in 2001. In fact, few of those old trust companies exist today—no Girard, no First Pennsylvania, no Provident Bank, no Fidelity Trust Company. They were succeeded by analysts at the few large-sized investment managers that remain here, including Wellington Management, Vanguard and just a few others. With $2.2 trillion of assets under management, and over 100 members of the CFA Society of Philadelphia, Vanguard has become the elephant in the room. Originally, our local money managers all worked in the city, but then started to move west of the city limits. Wellington moved to Valley Forge in 1974 when Vanguard began, and other firms followed. But we all remained part of the Greater Philadelphia region.

But our society, I think, is measuring the wrong bottom line: not only money over achievement, but form over substance; prestige over virtue; charisma over character; the ephemeral over the enduring; even mammon over God. Dollars became the coin of the new realm, and unchecked market forces totally overwhelmed traditional standards of professional conduct, developed over centuries. The result has been a marked change in our society. The traditional standard of conduct in which “there are some things that one simply does not do,” took a back seat to a new standard: “if everyone else is doing it, I can do it too.” I would describe this change as a shift from moral absolutism to moral relativism. The moral themes of virtue, loyalty, fidelity, faith, and honor have been debased. Business ethics has been a major casualty of that shift in our traditional societal values, and the idea of professional standards has been lost in the shuffle.

Vanguard Asset Growth 1,000 10,000 100,000 1,000,000 10,000,000 1974 1980 1990 2000 2012 Total Assets 2012 Total Assets: $1.93T 2000 $561 Bil 1990 $55.7 Bil 1974 $1.4 Bil $ (2) Of course, we were part of a burgeoning fund industry, whose assets rose from $50 billion to $12.5 trillion, thanks largely to (a) the greatest two-decade bull market in U.S. history (1980- 2000); (b) to the development of the money market fund; and (c) the huge increase in tax- deferred investment options such as the IRA and the tax-deferred thrift plans. But Vanguard grew far faster, (Chart 6) and our market share of 6 percent of industry stock and bond fund assets—after declining slightly through the late 1980s—has grown in each of the 26 years since, to today’s 17.4 percent. As far as I can tell, the previous highs in asset share for the industry’s largest firms regularly topped out at between 10 percent and 13 percent. So we are breaking new ground on industry dominance. Market Share of Long-Term Fund Leaders 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 1974 1980 1990 2000 2012 Vanguard Long-Term Market Share Market Share of Industry Leader* MFS 10.7% American 9.5% Fidelity 9.6% Vanguard 12.0% Vanguard 17.4% American 12.8% Fidelity 13.9% Fidelity 8.9% Fidelity 8.8% *Includes only firms with two or more years of leadership. Vanguard 4.1% Vanguard 10.6%

so on—the performance of their funds falls, as it must, well behind the returns provided in the stock market. In his foreword to my 1999 book Common Sense on Mutual Funds (updated and republished last year), the late eminent economist and prolific author Peter Bernstein made this pungent observation: What happens to the wealth of individual investors cannot be separated from the structure of the industry that manages those assets . . . [and] investment managers go right on earning a return on their own capital that most other industries can only envy. In the present manager-dominant structure of institutional investing, managers garner huge rewards and their clients get second shrift. If you doubt that, just compare the huge returns earned on the stocks of publicly-held management companies with the far more modest returns earned by even the best-performing of their funds. While we don’t know the exact profitability of the management companies that are owned by giant U.S. and international banks and financial conglomerates—now the dominant structure in the fund industry—aggregate profits must run to many billions. (In 2006-2009 alone, for example, Sun Life Financial reported operating profits of $1.5 billion from its mutual fund subsidiary MFS.) I suspect that the returns are even higher for the few large management companies that remain privately-held. (Example: Fidelity Management and Research reported net operating income of $2.5 billion for 2009 alone.)

citizenship . . . Yet we know that unless the urge to individual advantage has other curbs, and unless the more influential elements in society conduct themselves with a disposition to promote the common good, society cannot function . . . especially a society which has largely measured its rewards in terms of material gains . . . We must (square) our own ethical conceptions with the traditional ethics and ideals of the community at large . (There is) nothing more vital to our own day than that those who act as fiduciaries in the strategic positions of our business civilization, should be held to those standards of scrupulous fidelity which (our) society has the right to demand. This Columbia Leadership and Ethics Week of 2009 gives us all the opportunity to strengthen our resolve to meet that test.

Teacher Center FAQs RECENT GUIDES College, Inc. Obama's Deal The Vaccine War WATCHSCHEDULETOPICSABOUT FRONTLINESHOPTEACHER CENTER Why the '90 decline was much scarier than '87's......'My first stock purchase.'.....the investment lesson my wife taught me.....what it means to be 'good' in this business......the myth of 'market timing' Lynch ran Fidelity's Magellan Fund for thirteen years (1977-1990). In that period, Magellan was up over 2700%. He retired in 1990 at the age of 46.

In this business if you're good, you're right six times out of ten. You're never going to be right nine times out of ten. This is not like pure science where you go, "Aha" and you've got the answer. By the time you've got "Aha," Chrysler's already quadrupled or Boeing's quadrupled. You have to take a little bit of risk. When you first went to Fidelity, what was the market like? Well, after the great rush of the '50s, the market did brilliantly and everybody says, "Wow, looking backwards, this would be a great time to get in." So a lot of people got in in the early '60s and in the mid-60s. The market peaked in '65-66 around a thousand, and that's when I came. I was a summer student at Fidelity in 1966. There were 75 applicants for three jobs at Fidelity, but I caddied for the president for eight years. So that was the only job interview I ever took. It was sort of a rigged deal, I think. I worked there the summer of '66 and I remember the market was close to a thousand in 1966, and in 1982, 16 years later, it was 777. So we had a long drought after that. So the people were concerned about the stock market early in the '50s. They kept watching and watching, not investing. It started to go up dramatically and they finally caved in and bought big time in the mid-60s and got the peak.

So people got in at the wrong time, in effect? A lot of people got in at the wrong time. A lot of people did very well and some people said, "This is it. I'll never get back in again." And they maybe meant it, but they probably got back in again anyway. How much did you make on your first job at Fidelity? I was paid, $16,000 a year. I was an analyst. I was the textile analyst, the metals analysts, and I remember the second year I got a raise to $17,000. That was great, you know.

Did you get other job offers? I was in ROTC studies, I spent two years in the Army and I did two years of graduate school and in, a business at Wharton School of Finance, University of Pennsylvania. So I was about 25 when I joined Fidelity. How old were you when you took over Magellan? That was 1977, so I guess I was 33. What kind of fund was Magellan? It was a small aggressive capital appreciation fund. Magellan Fund basically started in the early '60s. In the name, it was an international fund, but right after it started in 1963, they put sort of a barrier and a heavy tax on foreign investing. So it did very little foreign investing. It had the ability to do it, but there was very little interest then. There was a big penalty. So even though it was Magellan Fund, it was primarily a domestic fund. And when I took over in May of 1977, the fund was $20 million.

And that was your first portfolio managing job? That's correct. I was director research in 1974. I still continued to be an analyst, and then May of 1977 I took over Magellan Fund. But the market really didn't do much between '77 and '82, between the beginning of that bull market, and yet your fund performed quite spectacularly. What do you do? Well, I think flexibility is one of the key things. I mean I would buy companies that had unions. I would buy companies that were in the steel industry. I'd buy textile companies. I always thought there was good opportunities everywhere and, researched my stocks myself. I mean Taco Bell was one of my first stock I bought. I mean the people wouldn't look at a small restaurant company. So I think it was just looking at different companies and I always thought if you looked at ten companies, you'd find one that's interesting, if you'd look at 20, you'd find two, or if you look at hundred you'll find ten. The person that turns over the most rocks wins the game. And that's always been my philosophy.

Do you think Vinik got a bad rap, too much emphasis put on short-term record? Jeff Vinik ran Magellan Fund for a little over four years. It beat the market. It beat 80 percent of all other funds. So if you went somewhere else, you would have been in the 80 percent that lost out to Magellan. Now the last nine months Magellan didn't have a great record, but when you have a basketball game and at the end of the game its 105 to 85, they don't say to the team, " the third quarter you lost by 32 to 22. What happened to the third quarter?" I mean I think a four years is a reasonable period of time to look over a record. I think Jeff Vinik did a very good job the time he ran Magellan.

What was Magellan's size when you left? When I left Magellan Fund, it was 14 billion. And where is it today? Today over 50 billion. What has caused that incredible influx of money? Well, part of it, the market was 2700 when I left. You know, and before today the market was 5500. So, the market doubled, plus dividends has brought a lot of it, and people already were there. So they kept adding. So every year people kept adding money and as it's gone up, it was up over 35 percent in 1995, I mean those compound to give you very big numbers. So it's some people adding do it and the fund doing very well. It went up when Morris Smith ran it. So it's gone up a lot in six years.

Transcript of Peter Lynch 8 October 1994 Lecture to the National Press Club [8:30] A native of Boston, Mr. Lynch is a 1965 graduate of Boston College and received his MBA from the University of Pennsylvania’s Wharton School of Business Education. He served as a lieutenant in the Army before coming to Fidelity in 1969. He currently serves as vice-chairman of Fidelity, sits on the boards of Morris-Knudsen and W. R. Grace and is heavily involved in charity work. Would you please welcome Mr. Peter Lynch.

[23:55] I did the same thing in my first or second year in Fidelity. Kaiser Industries had gone from $26 a share to $16. I said, “How much lower can it go at $16?” So, I think we bought one of the biggest blocks ever probably on the American stock exchange of Kaiser Industries at $14. I said, “It’s gone from $26 to $16. How much lower can it go?” Well, at $10, I called my mother and said, “Mom, you got to look at this Kaiser Industries. How much lower can it go? It’s gone from $26 to $10.” It went to $6. It went to $5. It went to $4, and it went to $3. I am fortunate this happened rapidly, or I would probably still be caddying or working at the Stop and Shop but it happened fast. It was compressed.

Beating the Street is Lynch's field report from the Magellan years, and its central methodological claim is the practice he called 'scuttlebutt' — getting out of the office and visiting companies, talking to competitors, suppliers, distributors, and customers, before reading the income statement. Lynch believed the visible financials were the residue of a story that had already played out at the operating level. The investor who walks a factory floor, sits in a competitor's parking lot counting delivery trucks, or visits three retail outlets in different cities has information that has not yet been priced into the stock because it has not yet shown up in quarterly filings. The Magellan fund under Lynch held over a thousand names at times, which is sometimes read as a contradiction of his scuttlebutt method. The reconciliation is that Lynch ran a hybrid portfolio: a core of conviction positions built on deep primary research, surrounded by a long tail of small跟踪 positions where the firm had a thesis but had not yet done the full work. The tail functioned as a watchlist with capital attached. When scuttlebutt confirmed the thesis, Lynch added; when it contradicted, he sold the small position cheaply. The wide net was a research infrastructure, not a portfolio construction belief in diversification for its own sake. Lynch's turnover at Magellan ran above 100 percent a year in the 1980s, sometimes above 300 percent in the early years. The high turnover is hard to reconcile with the public image of the patient fundamental investor. The truth is that Lynch was a relentless trader around a core of conviction names: he added on weakness, trimmed on strength, and rotated among the names whose stories were still intact. The fund's outperformance came less from buy-and-hold on individual picks than from the discipline of continuously re-allocating toward the names where the price-to-growth gap had widened.

Lynch's first chapter in Beating the Street describes the history of the Magellan Fund from its founding in 1963 through Lynch's tenure as manager from 1977 to 1990. The fund's beginning, in Lynch's account, was modest: a small fund with a few million dollars in assets, a research staff of one, and a portfolio that could be concentrated in a small number of positions. The fund's growth through the 1980s was rapid, driven by Lynch's research effort and by the favorable market for the small, under-researched names that Lynch's scuttlebutt produced. By the end of Lynch's tenure, the fund had grown to over fourteen billion dollars in assets, the research staff had grown accordingly, and the portfolio held over a thousand positions in companies across every industry. The fund's growth, in this sense, is the published record of the structural limits of the small-fund edge that Lynch exploited through the 1980s. Lynch's most instructive observation in the chapter is that the fund's growth changed the kind of investment Lynch could make. The small fund could buy the small, under-researched names whose market capitalizations were too small to absorb more than a token position; the large fund could not buy the small names without moving the price against itself, and the small names became, for the large fund, a rounding error in the portfolio's return. The growth forced Lynch to buy the larger, more researched names whose mis-pricings were smaller and whose returns were correspondingly less dramatic. Lynch's candid observation is that the fund's growth eroded the very edge the small fund had exploited, and that the erosion was the structural wage for the fund's success. The first chapter is, in this sense, the document in which the structural limits of the Magellan strategy are most candidly recorded. Lynch's third observation is that the fund's growth also changed the operational discipline the fund required. The small fund could be run out of a notebook; the large fund required a research organization, a portfolio-construction discipline, and a trading operation that could execute large positions without disrupting the market. Lynch's instruction is that the operational discipline is not a substitute for the analytical work; it is the complement to the analytical work that allows the analytical work to be applied at scale. The first chapter is, in this sense, an instruction in the operational discipline the active investor must build as his portfolio grows, and a reminder that the discipline of running a large portfolio is different from the discipline of running a small one. The chapter is also the document in which Lynch's reflection on the Magellan years is most directly recorded, and the document on which subsequent generations of fund managers have drawn for the structural limits of the small-fund edge.