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A Debt Premium?

A good year for leverage has been a great year for this fund.

Shannon Zimmerman, 11/08/2012

The books haven't yet closed on 2012, but the attributes that have led to success for mutual funds this year are coming into view. Among U.S. stock funds, bigger has mostly been better so far in 2012, with only the mid-cap value category surpassing Morningstar's three large-cap peer groups through the close of October. Barring a reversal of fortune between now and New Year's Eve, leverage will also rank among the year's performance contributors. Thus far in 2012, funds that favor more heavily indebted firms have fared better, on average, than those with lineups focused on financially healthier companies.

Crunching the Numbers
In the year to date through October, the Credit Suisse Leveraged Equity Index has outpaced the S&P 500 by roughly 2 percentage points. Leverage comes with the territory in the financials sector, and it's been the best-performing area of the market this year. Indeed,  Financial Select Sector SPDR XLF has sailed past the S&P 500 by more than 11 percentage points so far in 2012.

Year-to-date mutual fund returns offer further evidence of a debt premium in 2012. Through September, the U.S. stock fund universe's median debt/capital ratio is approximately 33.5. On average, funds whose debt/capital ratios tick above that figure place in their respective category's top half. Those with below-median ratios rank in the bottom half of their peer groups. The typical U.S. stock fund with an above-median ratio has gained roughly 13% this year, too, outpacing the below-median norm by roughly 2 percentage points.

Case Study and an Exception to the Rule
Not all funds that traffic in leveraged companies have met with success this year, of course. Gabelli Value GABVX and Ken Heebner's CGM Focus CGMFX are in their categories' bottom halves despite debt/capital ratios well above the U.S. stock fund median. And while on average higher debt/capital ratios have been associated with higher returns this year, no single factor accounts for any fund's performance.

Still, if 2012 has so far been a good year for leverage, it's been a great one for Fidelity Leveraged Company Stock FLVCX. Its gain of nearly 22% through the end of October places in the mid-blend peer group's second percentile. The fund is hardly a typical mid-blend offering, a point underscored by its official benchmarks, neither of which is a mid-cap bogy: the S&P 500 Index and the Credit Suisse Leveraged Equity Index. The fund has also surpassed those yardsticks this year, besting the S&P 500 by more than 5 percentage points and the Credit Suisse bogy by more than 7 points through October. (The fund's success has come, moreover, despite its modest allocation of just 6.4% of assets to financial stocks.)  

Leveraged Company Stock's latest portfolio lives up to the fund's name with a debt/capital ratio of 44.3; the comparable figure for the S&P 500 is 35.6. That's typical here. Led by former high-yield manager Tom Soviero since July 2003, the fund is essentially a poster child for vehicles specializing in the equity of deeply indebted firms. As of July 2012--the date of the fund's most recently disclosed portfolio--just nine other U.S. stock funds had higher debt/capital ratios.

Live by Leverage ...
Plenty of risk comes with the territory that Soviero targets. The fund got utterly crushed in 2008 when frozen credit markets took a severe toll on the stock prices of companies that rely most heavily on easy access to the capital markets. That year, Leveraged Company Stock lost more than half its value and placed in the mid-blend category’s 98th percentile, lagging the S&P 500 by nearly 18 percentage points.

That showing, in a word, was grim. It was also largely predictable, given the kinds of companies it gravitates toward. The fund's stellar 2009 campaign wasn't a surprise, either. Amid that year's flight to risk, Leveraged Company Stock rocketed into the category's top decile, notching a gain of nearly 60% and topping the S&P 500 by some 33 percentage points.

Shannon Zimmerman is an associate director of fund analysis at Morningstar.
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