Fidelity small-cap fund eyes a soft close

The Gold-rated Fidelity Future Leaders fund will close its doors to new entrants from January following strong interest from investors.

The Australian small-cap fund, whose assets have swelled to around $1.25 billion over the past seven years, said the size and depth of the small/mid cap Australian market means it's approaching maximum capacity.

The ASX ex-50 fund will no longer be able to receive applications from new investors. However, existing investors will continue to have the ability to make further applications, redemptions, or to reinvest distributions.

Morningstar senior fund analyst Michael Malseed described the decision as "prudent" in a recent note to Morningstar subscribers.

"Assets under management as at 30 November 2020 have grown to around $1.25 billion, which is sizable, but the mid-cap skew to the portfolio has reduced liquidity concerns to date," he said.

"This as a prudent decision aimed at preserving the strategy’s ability to outperform for existing investors, which we applaud."

Trailing returns since inception

Calculation Benchmark: S&P/ASX Small Ordinaries TR AUD

Source: Morningstar Direct

Fidelity portfolio manager James Abela has delivered a strong track record through a variety of market conditions. The fund has generated above-average returns over all rolling three-year periods since inception This year, the strategy has achieved outperformance of the S&P/ASX Small Ordinaries Index of 2.38 per cent.

Malseed notes that downside capture has also been exceptional at 59 per cent, meaning the strategy has fallen by much less than the benchmark during down months.

"Key contributors to this outcome have included early investments in tech names such as Aconex, WiseTech (WTC), and Altium (ALU); infant formula manufacture Bellamy’s Australia; and medical imaging software provider ProMedicus," he says.

"The only blemish on its record was a period of difficult performance in 2016, when an underweighting in materials stocks detracted as commodity prices rose sharply."

The August, the fund's largest positions were Charter Hall Group (CHC), Xero Ltd (XRO) and Evolution Mining (EVN). Abela added Seek Ltd (SEK) and Carsales.com Ltd (CAR) as major holdings to the portfolio in February.

This outperformance has propelled retail assets under management, from around $611 million in December 2019 to almost $1 billion today.

Fund size growth since inception

Source: Morningstar Direct

How much is too much?

Morningstar analysts have long spoken of the risk associated with strategies continuing to accept new investor money beyond their means - particularly for Australian small-cap funds.

At just over $236 billion, the S&P/ASX Small Ordinaries Index PR (XSO) is considerably smaller than the S&P/ASX 200 ($1.8 trillion constituent total market cap). It also contains a large swathe of stocks whose quality is too low to be considered investable by many managers.

As a result, once small, highly successful managers can find it difficult to maintain a liquid position in a small-cap stock, or seek out new opportunities, the more new money they take in. For example, if a manager runs an average position of 3.3 per cent in a single stock, if they take in more money, they need somewhere to invest it, which can lead them to own a large proportion of very small company. This can create a liquidity or trading risk if they choose to sell down their stake.

Staying open too long can also change the fund's profile if managers are forced to invest in more and/or larger companies to deploy growing investor capital.

"You want to stay nimble" Morningstar senior analyst Christopher Franz says.

Hard or soft closing a fund can be a difficult business decision for fund parents to make as base fees are often collected on assets under management. Morningstar analysts applaud those who do at the right time for their investors.

Fund capacity can be difficult for external observers to analyse because the limits can be different for each manager. "There's no magic number for the amount of assets that a specific style of investing can handle—it's dependent on the individuals running it, the process deployed, and the point of the economic cycle," says Morningstar's director of equity ratings Tom Whitelaw.

"There is no easy answer to the 'how much is too much' question but we continue to monitor the strategies we cover for any signs of detrimental asset bloat," adds former Morningstar senior analyst Kathryn Young says.

Growing beyond capacity can lead Morningstar analysts to downgrade a fund's rating, as occurred earlier this year in the UK. The Woodford Equity Income fund hit £10 billion in assets as investors chased Neil Woodford’s reputation and past track record before its notorious demise.

Fidelity notes the fund may re-open in the future and that they will continue to monitor the capacity of the fund.

Soft-closed funds under Morningstar coverage (AU)

Source: Morningstar Direct