FSCSX: active management in a narrow sector (MUTF:FSCSX)

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The Fidelity Select Software and IT Services Portfolio Fund (FSCSX) is an interesting fund. It is an actively managed fund that is limited to two rather narrow sectors: software and IT services. here’s how Loyalty describes the fund and its strategy.

  • The fund’s investment process is based on finding above-average companies with above-average growth rates and trading at below-average valuations, with the aim of generating strong adjusted portfolio returns to long-term risk. Our preference is to buy good companies at the right prices.
  • The portfolio is built on a stock-by-stock basis in a bottom-up fashion, seeking capital appreciation through both earnings growth and long-term valuation expansion. The fund favors self-funding business models with high barriers to entry and strong management teams, particularly if the shares can be bought at a favorable price.
  • Stock selection and idea generation comes from fundamental research that leverages Fidelity’s deep and experienced global technology team. We view tech stocks as attractive outside the benchmark that offer the potential for favorable risk-adjusted returns.
  • Sector and sector strategies could be used by investors as alternatives to individual stocks for tactical or strategic allocation purposes.

Whether or not active management can add value in such a narrow industry is interesting, especially enough to overcome a 0.72% expense ratio. FSCSX also does better in some areas of governance than many mutual funds we’ve seen. However, the active strategy pursued by the fund appears to result in some tax inefficiencies. We’ll look at how the fund invests, what restrictions are and aren’t in place for the fund, and its past performance. Then you can decide if it’s something you like or not.

FSCSX Portfolio and Strategy

The fund is primarily invested in US software and IT services stocks with some European and Chinese holdings.

(Graphic source: Fund website)

One thing we have to commend the FSCSX for is that the fund actually does what it says. All of the large holdings appear to fit the fund’s announced strategy. The fund is fairly concentrated (even when considering all holdings in the same or similar sectors).

(Graphic source: Morningstar)

Microsoft (MSFT) represents almost a quarter of the fund’s assets! Although Microsoft is a huge stock, it weighs “only” 15.1% in VGT, 0.92% in IGV and 0.71% in XSW. This means that the fund is overweight Microsoft by almost 10%. Thus, investors should be aware that they are not getting a diversified fund, both in terms of sector allocation and in terms of individual stocks.

Certain restrictions are also in place to ensure that the fund’s investment strategy will continue to match its name and marketing. Usually when we look at mutual funds, we find that the fund can tell investors that it will pursue a certain strategy, but when you read the fine print of the SAI, you find that the fund is pretty much ok to invest in what he wants. This makes it more difficult for investors because what fund you buy today may look very different in years to come. Fortunately, for investors, FSCSX is a little different. Even if the bar is set very low.

The fund’s ISC states that it must invest at least 25% of its assets in “securities of issuers whose principal activity is the computer software and services industry”. As we said, the bar is set pretty low, but at least 25% is better than zero. The fund is also prohibited from investing in commodities or real estate (unless they are derived or received from existing investments). And there are additional things that Fidelity says the fund “does not intend to do,” like buying on margin or short selling, but they aren’t strictly prohibited from doing so either.

High turnover and taxes

The final problem with the fund is that of tax efficiency, or lack thereof. Below are the returns (using net asset value) of the fund before and after tax as well as the pre-tax returns of several other index funds in the same industry.

The fund’s turnover rate was 48% for the past year. In fact, looking at the fund’s after-tax returns over the past 10 years, it appears that the fund has always had a fairly high turnover rate.

The high turnover nearly eliminates any performance gains the fund has for households in one of the highest tax brackets. For investors in lower tax brackets, the picture of returns is still mixed. Other funds had a turnover of 12% (IGV) or 7% (VGT) and the tax bite was only around a tenth of a percentage point of performance.

Summary

Ultimately, we don’t see a very compelling reason to pay 0.72% for a fund with such a narrow investment universe. Past performance shows that the fund may indeed have beaten all relevant benchmarks, but for investors in a high tax bracket, the gains disappear. For investors looking to try their luck with an actively managed information technology mutual fund, FSCSX doesn’t look too bad. Just keep an eye on this big Microsoft holding!

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