Investors Behaving Badly

From its name to its strategy to its battle-tested manager's background as a high-yield credit researcher,  Fidelity Leveraged Company Stock lives (FLVCX) and dies by its mandate.

Twenty-two year Fidelity veteran Tom Soviero has run this unusual mid-cap blend fund since July 2003, delivering wildly volatile yet in some ways utterly predictable performance. En route to a category- and benchmark-shellacking cumulative return of nearly 153% between his arrival and June 2011, the fund has enjoyed approximately 1.3 times the category's gains--and an almost exactly proportionate share of its losses.

Just as predictable: As they often do with such volatile vehicles, investors have had a difficult time using this fund well. The mammoth gap between its 10-year total return (13.6%) and investor return (3.2%) makes it a nearly perfect example of the kind of funds that reward the kind of patience not many investors actually have.

Which is in some ways understandable. Staking out equity positions mainly in debt-laden, below-investment-grade firms, after all, is risky business, and this fund tends to fare best when investors' appetite for risk grows. It soared, for example, during 2009's so-called junk rally. Amid signs the economy wasn't going belly-up, shares of companies with less-than-robust financial health raced ahead, and the fund thumped average rivals by 22 percentage points. Its gain of nearly 60% on the year secured a spot in the peer group's top decile.

The Not-So-Shocking Truth
During the previous year, of course, the fund had fallen into a performance chasm, losing more than 37% in 2008's fourth quarter alone. Amid the year's supersonic flight from risk in general--and from debt in particular--the fund took a nosedive, clipping off more than half its value and crash landing in the category's 98th percentile.

That was just as understandable as 2009's equal-but-opposite trajectory. Still, while neither year's results should surprise anyone familiar with the fund's history and its mandate, flows data indicate that many investors weren't just surprised--they were shocked.

Since 2008, Fidelity Leveraged Company Stock has hemorrhaged money. Outflows began modestly, with the fund experiencing net redemptions of $90 million over the course of 2008, according to Morningstar's estimates. The trickle has become a torrent in subsequent years. Despite 2009's success, $283 million headed for the exits; in 2010, shareholders redeemed almost $800 million worth of their shares.

Outflows persist, but the pace has slackened of late, and Soviero says the more incremental nature of recent redemptions hasn't posed a problem from his perspective. Still, for the year to date through June 2011, it's suffered another $160 million exodus, leaving the fund's asset base, while still substantial at $4.2 billion, at just over half its 2007 figure.

Suffering Succotash
It's not merely, or even mostly, the fund that's suffering. Given the tidal wave of outflows and the hand-forcing effect they can have on a manager's process, the fund's performance has actually held up better than one might expect.

In addition to its sterling 2009 showing, shareholders enjoyed a 22% gain in 2010--middling performance in relative terms but still a solid absolute return. And the fund has gained more than 27% in the past 12 months. While it lags the peer-group norm on a year-to-date basis, a modest rise of roughly 5% thus far in 2011 owes to a familiar pattern: The fund edged past average rivals as the category climbed during the year's first quarter but lost ground amid the peer group's slight second-quarter decline.

Admittedly, the fund's trailing three-year return is poor. Still, disastrously impatient shareholders have fared far worse. Based on dollar-weighted returns--which account for money flows into and out of the fund--the typical investor added self-inflicted insult to injury, suffering an 11.2% loss while the fund declined an annualized 3.7%. That same investor also lost money during the five-year period even though the fund ticked up by nearly 4% in the stretch.

Perhaps the most dramatic example of the fund's performance divide is the one I noted above: the gulf during the past 10 years, eight of which have featured Soviero at the helm. In that timeframe, the fund's 13.6% annualized gain earns a spot in the category's third percentile. Typical investors, however, have garnered just a fraction of that amount: a 3.2% return that hovers near the category's bottom quintile.

Horns of Dilemma
Fidelity Leveraged Company Stock is a conundrum. The fund's name essentially shouts its strategy. Its manager, who has enjoyed success at several other Fidelity charges, has executed it deftly. A significant investor in the fund, Soviero has become a bit more risk-averse since 2008. He's now more willing to let cash build and to hold erstwhile high-yielders as they climb up the credit-quality ladder.

That creeping conservatism isn't a point in the fund's favor, but the change is more evolution than revolution. Soviero's high-yield DNA helps ensure strategic consistency, and his track record of peer-besting returns--and also the way he's generated them--is clear. Low fees versus the broad peer group and within the universe of no-load mid-cap funds burnish this fund's appeal. And Soviero's unusual approach makes this racy vehicle a viable candidate for complementing a portfolio's core mid-cap exposure, too.

Still, the inability of many investors to use the fund well is almost as consistent as Soviero. Investor returns have improved during the past 12 months, but in all trailing periods of three or more years, they rank among the peer group's worst.

I cover Fidelity Leveraged Company Stock for Morningstar. As an analyst, I try to square the vicious circle outlined above by giving Soviero credit where it's due but encouraging prospective buyers, not to beware, but to be aware of the fund's mandate and its penchant for wild performance swings.

Therefore, the fund gets a high recommendation, but a qualified one. What's yours? Could you use this fund well? Or, if you're an advisor, could your clients? Share your take in the comments area below.