What to Make of Fidelity Fund Closings

A version of this article appeared in the August 2006 issue of Morningstar's Fidelity Fund Family Report, our monthly newsletter dedicated to helping Fidelity investors find superior long-term investment opportunities. To review a risk-free trial issue of our Fidelity Fund Family Report, click here. Fund Family Reports on Vanguard and American Funds are also available.

This has been a watershed year for Fidelity. In the first half of 2006 alone, the shop closed six funds--more than in any previous year, by far. This brings the total number of closed, no-load Fidelity funds to 10, and closed advisor-sold funds to two.

Judging by the emails I receive about fund closings and the debates such events can trigger on Morningstar.com's Fidelity Family discussion board, there seems to be a lot of questions surrounding the topic. Why does Fidelity close funds? Are fund closings good for investors? And, most importantly, what should you do with your money when a fund you own or want to own shutters its doors? Here I'll tell you which of Fidelity's closed funds are holds and which are sells, in my view. I'll also name some Fidelity funds I'd like to see close.

Protecting Shareholders
Right off the bat, let me just say that I see the closings in 2006 as a good thing. By closing a fund, a mutual fund advisor is acknowledging that asset bloat threatens the portfolio manager's ability to maneuver (We've addressed this topic on several occasions.)

I see the argument that Fidelity has a duty to offer investors an open option in every asset class as hogwash. A fund is run for the benefit of its existing shareholders. If their interests are best served by closing the fund, tough luck for those on the outside. There are shops like Tweedy, Browne, whose only funds are closed. There are others, like Bridgeway, Wasatch, and Longleaf, that close funds soon after they open to stave off the deleterious effects of bloat.

A Red Flag
Many investors feel as though they're missing a party when they can't invest in a closed fund; some try to quickly hop aboard before the close. They shouldn't. Morningstar has conducted two studies, one in 1999 and one in 2004, showing that funds tends to underperform after they close.

One reason is that many closed funds are already so bloated that they lose their edge. My colleague Russ Kinnel has devised a measure called the "bloat ratio," to gauge the effects of asset growth. To calculate the bloat ratio, we multiply a fund's turnover rate by how many average days' trading volume it owns of its top 25 positions. Then we compare the fund with its category peers. I'll be using the bloat ratio when I discuss individual Fidelity funds. 

The more crucial reason that closed funds underperform is that they're often focused on hot corners of the market that have become overvalued. Lots of closings in a particular asset class can be seen as a sign of the top. Take all the fund closings in 2000. Most of those shuttered were of the aggressive-growth, tech-oriented variety. It's hard to believe now, but Munder NetNet (now  Munder Internet (MNNAX)) shut its doors in March 2000, with $11 billion in assets. Then it fell of a cliff.

What's been hot lately are smaller caps and emerging markets. Given that both are rather illiquid, it's unsurprising that the number of fund closings has increased each year since 2001. With that, let's take a quick look at the prospects for each of Fidelity's closed funds (no-load only), working backwards in order of closing date.

 Fidelity Small Cap Stock (FSLCX) (closed June 2006)
I see this as a classic example of a fund closing signaling the peak of an asset class. At $4.5 billion, the fund's asset base is big by small-cap fund standards. We've seen some classic signs of strain in recent years, including more liquid large caps popping into the portfolio and a higher cash stake. The fund's bloat ratio is higher than 99% of small-cap blend funds. Only because I think Paul Antico is a talented manager is this one a Hold.

 Fidelity Mid-Cap Stock (FMCSX) (closed April 2006)
Mid-caps haven't had quite the run that small caps have, but I see this fund's closing in a similar vein to Small Cap Stock's. With nearly $12 billion in assets, this fund is the biggest of its kind, and Fidelity has a huge footprint in the mid-cap space. Its bloat ratio is very high, and it will continue to gather assets because it's on a fair number of 401(k) platforms and it is a constituent of Fidelity's Freedom Fund lineup. Unlike in the case of Small-Cap Stock, this fund's manager is not long-tenured and proven. I consider this one a Sell.

 Fidelity Growth Company (FDGRX) (closed April 2006)
To me, this has been the most forward-looking closing of 2006. It's designed to preserve longtime manager Steve Wymer's ability to invest in the manner that has yielded success here, which includes buying some mid-cap and smaller large-cap stocks. Unlike many of the other funds on this list, Growth Company hasn't shown many effects of bloat, though it does have nearly $28 billion in assets. You haven't heard me talk about this fund much because I don't view it as a contrarian play and therefore wouldn't load up on it right now. But a future reopening, after the fund has cooled off and asset flows have slowed, could be a good time to jump in. This is a Hold.

 Fidelity Contrafund (FCNTX) (closed April 2006)
This fund is an enigma--the largest equity fund actively managed by a single investor. At nearly $65 billion, it is the biggest Fidelity fund, and, judged by the bloat ratio, it's the most bloated fund in Fidelity's lineup and in the large-growth category. Those numbers actually understate the situation, because manager Will Danoff runs another $7 billion in  Fidelity Advisor New Insights (FNIAX), which also closed. I think this fund's closing came too late and see Contrafund continuing to gather 401(k) assets. I'd send new investors elsewhere, but because Danoff is a brilliant investor, I think existing investors should Hold.

 Fidelity Japan Smaller Companies (FJSCX) (closed February 2006)
This fund was already in the midst of tanking when Fidelity shut the door in February, at more than $2 billion in assets. It rode the tremendous surge in Japanese small caps to phenomenal gains, and its closing was a classic sign that the asset class had peaked. If losses continue, I'd expect outflows. Watch for a reopening as a possible sign that Japanese small caps will rebound. Hold.

 Fidelity International Small Cap (FISMX) (closed May 2005)
This fund was launched only in 2002, but stellar initial results led to sharp asset growth, which in turn led to a closing. The fund has shown clear signs of strain, including large caps creeping into the portfolio and a huge increase in number of holdings. I think the fund is still too big ($2 billion in assets); the portfolio managers too unproven; and the fact that Fidelity launched another foreign small-cap fund to compete with this one for name ownership worrisome. Sell.

 Fidelity Diversified International (FDIVX) (closed October 2004)
It's been frustrating to watch this fine fund continue to swell long after its closing. When it shuttered its doors two years ago, it had $18 billion; it now has $40 billion. To be fair, appreciation has played a part in that, and if foreign markets cool, as they may have started to, assets could stabilize. I still view this as a superb core foreign fund. Manager Bill Bower is one of the best foreign-stock-pickers around, and his low-turnover style and sprawling portfolios help him cope with the bloat. Hold.

 Fidelity Low-Priced Stock (FLPSX) (closed most recently in December 2003)
We've made a lot over the years of how big this fund is (at $40 billion, it's the largest small- or mid-cap-focused offering around), how the portfolio holds a bigger chunk of large stocks (we recently moved the fund from the small-blend to the mid-blend category), and how bloated it is (it owns a huge amount of trading volume of several stocks). But the fund fits into the same category as Contrafund. I'm comfortable calling manager Joel Tillinghast a genius for his 17 years of handiwork here. While I have a hard time believing that the future will look as good as its past given size issues, this fund is a Hold.

 Fidelity Magellan (FMAGX) (closed September 1997)
This fund's asset base has shrunk to its smallest size in more than 10 years. But that doesn't mean I think Fidelity should reopen it. Asset bloat took a heavy toll on this fund, and I'd hate to see new manager Harry Lange's flexibility impeded early on. Plus, the fund is still bloated, measured by the bloat ratio. I like Lange's investment style a lot, and I think the fund has a better chance of success now than at any point in the last decade, so I think it's a Hold.

 Fidelity New Millennium (FMILX) (closed May 1996)
This one is a rare bird: a Fidelity fund that announced its plans to close from the get-go and shut its doors at a svelte asset size. Unfortunately, the fund's eccentric and extremely talented manager, Neal Miller, just retired. I wouldn't be too troubled if the fund reopened--it is an all-cap vehicle with just $3.3 billion in assets--but the new manager is unproven. It's a Sell.

Let me conclude by mentioning a few Fidelity funds that I'm monitoring closely for signs of asset bloat and could probably stand to be closed already.  Growth & Income (FGRIX) has a bloat ratios higher than 99% of its peers.  International Small Cap Opportunities (FSCOX) is just a year old and already has $1.1 billion in assets, past the point at which many foreign small-cap funds close.  Select Electronics (FSELX) has a disturbingly high bloat ratio. And finally, I'm getting worried about  Real Estate Investment (FRESX), which is the largest actively managed REIT fund on the market. In short, I hope we haven't seen the last of Fidelity's fund closings.