The Industry Leaders Index

Fidelity Magellan, widely known as a stock fund, is an example of what can happen when managers drift from their expected style. In the first half of 1996, then-manager Jeffrey Vinik invested heavily in bonds, placing nearly 20% of the fund's assets in bonds by the end of April of that year. When stocks rose that summer, Magellan's performance significantly lagged the market. As a result, the fund underperformed the Standard & Poor's 500 by more than 9% for the year, the worst relative performance of the fund in its history.

The Industry Leaders Fund buys and holds exactly what its name implies: the top companies from more than 50 industries. In this interview, fund manager Gerry Sullivan explains how he avoids style drift.

Can you summarize your investment management philosophy?

The fund is managed by strictly following a proprietary investment process, the industry leaders strategy model, and invests its assets in accordance with the Industry Leaders Index (ILI), which is produced by the strategy model. The strategy is a straightforward one, and the fund consists solely of industry leaders.

How do you define an "industry leader"?

Starting with the Value Line Investment Survey, we identify the stock in each industry group with the highest common shareholders' equity. These are the leaders we want to own.

Why common shareholders' equity? Why not buy the stock with the highest market capitalization, or with the best recent performance?

Common shareholders' equity, or book value, is the most conservative value of a company, unaffected by the emotional expectations that move stocks in and out of favor. Book value is a historical accounting value of a company, defined as its assets minus liabilities, preferred stock, and minority interests. It reflects historical earnings and investors' cumulative capital contributions, both of which are measures of a company's strength and longevity.

What's the next step in the process after you identify the leaders?

We test the credit quality of the companies with the largest book capital in their respective industries. We require the company to have a senior debt rating of "single A or better" by Moody's Investor Services and Standard & Poor's. If this credit screen is met, the industry and industry leader are included in the ILI universe.

Next, the book value of each industry is calculated and a grand total of common shareholders' equity is calculated for all industries included in the index's universe. A portfolio allocation is assigned to each industry based upon the ratio of industry book value to the grand total.

For each industry that passes the credit quality screen, the company with the largest book value and the requisite credit rating is chosen as the industry leader, and is allocated the weight of the industry. To remain diversified, the fund limits the holdings in any one company to 2.25% of the portfolio. Subsequently, any industry larger than 2.25% of the universe requires more than one industry leader.

Does credit quality make a noticeable difference in the performance of your model?

The credit quality requirement of "single A or better" has improved the performance results of the ILI by an average of 1.6% per year for 12 years, versus the same process without the credit screen. The credit screen kept us from owning stocks such as Enron, Tyco, AES Corp., Worldcom, and Qwest.

This model is the result of more than two years of research. What objective did you begin the research with?

I was fascinated by "the parade of fools." With cable channels dedicating 10­16 hours to business per day, I was shocked to see how bad many of the "professionals" were. At the same time I was studying Vanguard's approach to index investing, as well as the S&P 500. My study of the S&P 500 found it to be actively managed on the perimeter, and not representative of the largest 500 companies in the US. I found that Microsoft was left out of the S&P 500 for at least seven years. When it was included in the S&P 500 in 1994, Microsoft ended that year as the 12th-largest capitalized company in the index. All this pushed me toward making a new index.

I have studied the "value vs. growth" analytical research by Gene Fama and Kenneth French, who were both professors at the University of Chicago in 1984 when I attended that school as a graduate student. I remembered being taught in my corporate finance class that a company's book value was irrelevant. I thought, "What if there was something to book value, what would that do to a portfolio management system built on it?" I discovered that all value indexes were market cap­weighted and based more on expectations than on a consistent foundation formed by book value. So I set out to build a value-styled index that was consistently based on book value.

You felt the investment community needed another index?

Since we do not weight our portfolio by market capitalization, our index carries a different combination of stocks from the garden-variety market-cap index. Indexes based on market capitalization multiply price and outstanding shares to calculate a company's worth.

The same factors, price and shares outstanding, drive all market capitalization­weighted indexes. Our index determines the amount of investment and choice of investment without regard to the price or shares outstanding of an equity.

Market capitalization is based on expectations and is significantly more volatile than book value. We combine a different valuation (book value) and an innovative, yet disciplined weighting method that uses industry book value and size of the industry's largest book-valued company, as well as a minimum credit rating requirement. Our process is so unique that there is actually a patent pending on the process that creates the ILI. The "A or better" credit screening brings a bond market analytic tool to an equity index portfolio, enhancing risk management.

How has the Industry Leaders Fund performed?

According to Morningstar, the Industry Leaders Fund is a top-quartile performer in its category (large-cap blend) for the fund's first two calendar years. We ranked in the top 18% in 2000, the top 6% in 2001, and in the top 2% through March 12, 2002. From its inception to that date, the fund has outperformed the Vanguard S&P 500 by 11.13%. In addition, the SEC has allowed 10 years of hypothetical past performance to be included in the fund's prospectus. The cumulative 10-year (through February 28, 2002) past performance return of 319% for our "Institutional Class L" (0.38% annual expense ratio) significantly outperformed the S&P 500's return of 228%.

According to the Bloomberg Professional Service database of mutual funds, the Industry Leaders Fund Class I was the best-performing large-cap domestic equity index fund for 2000 and 2001. As of March 12, 2002, it is in the top 5% of its category.

Why did the SEC permit you to cite hypothetical performance in your prospectus?

We presented the detailed methodology behind our index results, which satisfied the SEC's disclosure requirement. We follow the method presented in our prospectus. Our investment strategy can be replicated and does not have the latitude found in all actively managed funds.

Why buy this fund instead of a value or growth index fund?

Because of the way they are constructed, a value index fund would not have any "pure-growth" stocks, while a growth index would have only pure-growth stocks. For example, Barra growth and value indexes are calculated using the ratio of book value to market capitalization. The S&P 500 Barra Growth Index consists of the stocks with the highest ratio representing 50% of the overall index market cap. In this way, a universe of stocks, the S&P 500 in this case, can be divided into growth and value categories. Companies in the growth index usually have higher market capitalizations, and as a result, there are more companies in the value index than the growth index.

According to a Frank Russell Co. analysis, at the end of December 2001, we held 16% pure growth stocks, versus the S&P 500, with 34% pure growth. Our value methodology includes growth stocks, but they are weighted by book value, and so our concentration in this area is less than that of the S&P 500.

We are a long-term investment fund and have historically done better than value, growth, or blend indexes because we offer a balance that neither value nor growth indexes represent. A value or growth index would represent a gamble for short-term gain, but add no diversity to a portfolio. The combinations of stocks found in a growth or value index are found in the S&P 500, so the index increases risk in certain stocks rather than reducing risk. Our approach represents a risk-reduction strategy that increases diversity and can increase performance.

Of our 77 stocks, 74 are members of the S&P 500 and therefore are members of either the S&P Barra value or S&P Barra growth indexes.

Given the strict discipline you employ, we would expect the fund to have relatively low turnover, yet in the year ended June 30, 2001, you reported portfolio turnover of nearly 150%. Why?

Since we rebalance monthly and intramonthly, with a static asset pool, we generated a lot of turnover. In a more traditional positive cash flow environment, we would not have near that turnover. Our portfolio resembles a positive-gamma stock option portfolio. When a stock appreciates at a higher rate than its peers, we lighten our position in that stock. When a stock drops at a faster rate than its peers, we add to our position. We maintain the proper percentage allocation. We also tend to buy oversold stocks and sell overbought ones.

What's a positive-gamma stock option portfolio?

When you hold a properly hedged options portfolio, you balance risk with the underlying security. One at-the-money equity call (representing the right to purchase 100 shares at the strike price), for example, would be offset by selling 50 shares of the underlying. As the underlying stock increases in value, the hedged position becomes "longer," and to rebalance the position, shares of the underlying would be sold. The opposite happens when the underlying equity drops in price.

The ILI is different from this option example in that the Industry Leaders Index does not have time decay the way an option does. We are attempting to capture oversold stocks while lightening our position in overbought securities. A market capitalization­weighted index is perpetually balanced, and does not offer the potential for rebalancing.

Do you have any views on the current market?

I believe in having an asset allocation plan that meets your needs and fits your retirement horizon and appetite for risk. A fine balance between equities and fixed income/cash enables you to weather any market. I sleep soundly knowing that we provide one of a limited number of tools needed to achieve proper asset allocation. My personal views on the market do not affect the way we manage our fund.

Thank you, Gerry.

Mike Carr can be reached at mikecarro5@hotmail.com.

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