Are Fidelity's Small-Cap Funds Too Bloated?
Fidelity's problem may not be the size of its small-cap funds but the girth of its larger siblings.
One unforgettable childhood memory involves my rather rotund grandfather and a swimming pool. The pool was pint-size, while Grandpa was nearly as wide as he was tall. I knew there was no way he could jump in without making a few waves, and he didn't disappoint. I suppose he could've gently waded in, but that wasn't his style. His girth--mixed with his running leap--sent giant ripples through the water, some of which splashed over the sides of the pool.
Grandpa obviously didn't mean to teach me a lesson about investing, but he did. Plus-size mutual funds, like plus-size people, have a tough time jumping into small pools without a big splash. The larger the fund, the harder it usually is to invest in small-cap stocks. A $100 million fund can easily build meaningfully sized stakes in smaller names. If it wanted to establish a 3% position in a stock with a $1 billion market cap, it would own just 0.3% of the company's shares. The fund could quickly buy or sell all of its shares with little noticeable impact on the stock price. Should that tiny $100 million fund grow to $3 billion--a not unheard of occurrence--a 3% weighting translates into more than 10% ownership of the company. In this case, not only would it probably take a lot of time to accumulate that many shares, it would be hard to back out if the company's fundamentals head south. That's especially a problem for managers that trade often, as Fidelity's are wont to do.
Just as Grandpa could have done more to control his diet, funds can limit the possibility of bloat by limiting how much new money they take in. But instead of closing to new investments or otherwise restricting the tide of inflows, portfolio managers can simply adapt their strategies to fit their funds' larger size. They might own more stocks and fewer small caps. They may also tone down turnover because it's a lot harder to trade a big portfolio than a smaller one. A handful of exceptional investors, such as Fidelity Contrafund's (FCNTX) Will Danoff, have been able to adjust their approach to manage a lot more money without giving up much on the performance front. But for every Danoff, there are scores of lesser managers who can't replicate their past success because their strategies don't translate well to a bigger asset base.
At first blush, Fidelity's size problem doesn't appear especially acute. Of its eight small-cap funds, just two have more than $2 billion in assets. While most of the funds may be pretty manageable in size, they represent a much larger footprint when taken as a whole--$13.4 billion in total. Only three firms, American, Vanguard, and T. Rowe Price, have more small-cap assets.
That understates the extent of Fidelity's small-cap holdings, however. To get a truer measure, I examined parent company FMR's latest 13F filing, a once-quarterly SEC document detailing its firmwide positions. As of September 2009, FMR had roughly $46 billion invested in small-cap stocks (Morningstar currently puts stocks with market caps below approximately $2 billion in the small-cap bucket.)
Because of its girth, Fidelity can't help but to own big slugs of its small-cap investments. By my estimate, about 53% of the value of its small-cap investments is in stocks where it owns 10% or more of the company. If it wanted to unwind its stakes in those companies, it would take a lot of time. On average, Fidelity's 10%-plus positions represent 25 days' worth of the stocks' average daily trading volume. Despite a ruthlessly efficient trading operation, it would take even longer to unload them completely because Fidelity wouldn't be the only seller out there.
It's Getting Mighty Crowded
In many cases, though, the most heavily owned small-cap stocks at Fidelity aren't the small-cap funds' biggest holdings. That's because funds across the firm's lineup also invest in small caps. Mid-blend Fidelity Low-Priced Stock (FLPSX), for instance, has about 35% of its $26.5 billion portfolio in small-cap stocks. (The fund was dominated by small caps until its burgeoning size forced manager Joel Tillinghast to buy more mid-caps.) Even funds with modestly sized small-cap weightings, such as Contrafund, still end up being big owners by virtue of their hefty asset bases.
I had expected to find that small caps that had found their way into the likes of Low-Priced Stock or Contrafund would be favorites of the small-cap funds as well. But I was often surprised to see that Fidelity's biggest small-cap bets were scarcely seen in its small-cap funds. No Fidelity small-cap fund ranks among 20 largest fund owners of Papa John's International (PZZA), for example, but Low-Priced Stock and Contrafund together own around 10% of the company's shares.
There are a couple of reasons why Fidelity's heaviest small-cap investments don't often play big roles in its small-cap funds. One explanation may stem from where the small-cap fund managers get their research. In 2006, Fidelity created a dedicated team of analysts to focus solely on small-cap stocks. Its huge central research effort was especially focused on larger-cap stocks, giving smaller names less attention. The small-cap team is relatively small (around five or six analysts), but because it's not spending time covering giants like ExxonMobil (XOM) and Apple (AAPL), it can focus on finding small, undiscovered gems that the broader analyst group misses.
It could also be the case, however, that the small-cap funds own different stocks because behemoths like Contrafund and Low-Priced Stock crowd them out. After those offerings get their piece of the pie, there just isn't a lot left over for everyone else. With the funds alone owning 11% of Papa John's, the small-cap funds would have a hard time building big weightings too without pushing up against Fidelity's firmwide ownership limits, which generally are around 15% of any company. That makes me wonder whether the best way to invest in small caps at Fidelity isn't through the small-cap funds at all.
Investing in Small Caps without a Small-Cap Fund?
I'll provide my take on each of Fidelity's small-cap funds in the next section, but here's a sneak preview: A few have potential but none are truly compelling. Not yet, at least. And it's a sad reality that none of Fidelity's most-proven stock-pickers invest exclusively in the small-cap arena. But fortunately, you don't necessarily need a small-cap fund to get small-cap exposure. As I mentioned earlier, about a fourth of Low-Priced Stock's portfolio is devoted to small caps, with the balance made up by a slug of mid-caps and a smattering of larger names. With Low-Priced Stock, you can get your mid- and small-cap fix in a single package. Plus, you're investing with Joel Tillinghast, whom I regard as one of best money managers around.
Low-Priced Stock was a small-cap fund during most of its existence, so it's natural to regard it as a plausible small-cap vehicle. Fidelity Dividend Growth (FDGFX), on the other hand, historically has focused on blue-chip dividend payers, especially under former manager Charles Mangum. New manager Larry Rakers, however, employs an eclectic, all-cap approach. His wide-ranging portfolio spans virtually the entire Morningstar Style Box, with about 16% of it invested in small caps. Rakers enjoyed great success implementing the same strategy running the equity sleeve of Fidelity Balanced (FBALX), and I don't see why he can't repeat his success at Dividend Growth. In fact, it might be easier because Rakers is managing less money at his current charge. Conceivably, Dividend Growth is broad enough to be your only (or nearly the only, should you want to include alternative asset classes such as commodities and real estate) domestic-equity holding.
Unfortunately, some otherwise great funds don't fit the bill. With $62 billion in assets, Contrafund is too large to invest meaningfully in small caps; its weighting is less than 3%. That's too bad because one of manager Will Danoff's strengths is asking company managements the right questions, and I know he takes the time to get to know IPOs and other newly public firms. He just manages too much money for shareholders to reap the benefit.
The Lowdown on Fidelity's Small-Cap Lineup
There are definite advantages to investing in a small-cap-focused fund. Most Fidelity dedicated small-cap funds aren't too big, so their managers have added flexibility. Joel Tillinghast may be an extraordinary investor who can tell you just as much about his top holding as his smallest, but it's still the case that most of his picks account for a miniscule piece of his 800-plus stock portfolio. Having a dedicated small-cap fund also makes sense from a portfolio-planning standpoint because you're better able to control how much small-cap exposure you have. And depending on the options you have in your retirement plan, it may be the case that the only plausible way to gain access to small caps is through a dedicated small-cap fund.
For all-weather small-cap exposure, I'd say Fidelity Small Cap Discovery (FSCRX) appears most promising (the fund recently changed its name from Small Cap Retirement to reflect that it is not exclusively limited to retirement plans). I say promising because manager Chuck Myers doesn't have a very lengthy track record to go on. But his value-leaning, Warren Buffett-esque strategy is appealing, and it's impressive that Myers not only beat the competition in rough-and-tumble 2008 but also has stayed ahead of the pack this year. Myers also runs similar Fidelity Small Cap Value (FCPVX), but I'd opt for Small Cap Discovery if it's going to be your only small-cap holding.) I'd put Fidelity Small Cap Growth (FCPGX) in a similar camp. Overall, manager Lionel Harris has executed his valuation-conscious take on growth investing well, but his track record extends back only to April 2005.
I'm more leery of Fidelity Small Cap Stock (FSLCX). Manager Andrew Sassine has only been on board for about a year (previously, he led Fidelity International Small Cap (FISMX) with subpar results), and I'm not convinced his racy style will pay off. Fidelity Small Cap Independence (FDSCX) recently adopted a multimanager approach, whereby a group of sector specialists will independently run sleeves of the portfolio according to their specialities, which is unproven. Finally, Fidelity Advisor Small Cap (FSCTX) is suffering many of the tell-tale signs of asset bloat. Over the past year, its portfolio has become much less concentrated and now mid-caps comprise the largest chunk of the portfolio.
In small caps especially, I think it makes sense to invest outside of Fidelity if you can. Its no-transaction-fee brokerage has some appealing choices. One of my favorites is small-blend Royce Low-Priced Stock (RYLPX). As its top-rate record indicates, management is superb. Moreover, the fund also offers ample exposure to micro-cap stocks, a class of small caps that Fidelity doesn't much touch.
Christopher Davis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.