I wouldn't blame you if you decided to turn your back on actively managed funds altogether. After all, study after study has shown that 80% or more of actively managed funds have failed to beat their benchmark over just about any time frame that can be measured. If you do that, though, you're missing out on some high quality funds such as the Fidelity Low Priced Stock Fund (MUTF:FLPSX).
Low Priced Stock has always been a bit of an oddity to me. Narrowing down your universe of potential stocks by their share price, an essentially random and meaningless number, always struck me as curious. I've never spent a whole lot of time thinking about it, though, because the fund has one of the best in the business, Joel Tillinghast, behind the wheel. Tillinghast has been lead manager of Low Priced Stock since the fund's inception in 1989. During that time, the fund has delivered an average annual return of over 13%, far outpacing the 9% average annual return of its benchmark, the Russell 2000.
But things haven't been quite as good for Low Priced Stock recently. Over the past five years, the fund has been relatively average. It has slightly trailed both the Russell 2000 and Morningstar's Mid Cap Value category average. It's been outperformed by roughly 60% of comparable funds and seen its overall Morningstar rating drop to just three stars. Should Low Priced Stock shareholders be concerned?
Buying shares of an actively managed fund is essentially betting on the manager's ability to pick winners. Tillinghast has historically done a great job of this, but has anything changed lately to make us think that things have changed? There could be a few reasons for the fund's modest recent performance.
Avoiding higher yielding equities
In a recent commentary, Tillinghast discussed underweighting areas of the market like real estate and utilities. Tillinghast typically favors discounted areas of the market and these groups became quite expensive as investors flooded in. These sectors proved popular during the past 2-3 years as investors searched for higher yields in a zero interest rate environment and ultimately performed very well. Tillinghast said…
"I have largely avoided these categories, because I think they are quite expensive when measured on a price-earnings basis. But, given that the entire market has been skewed by investors' desperate frenzy for yield, we lost out this period by not owning them."
The logic was sound but, in practice, this time it didn't work out. The fund still has next to nothing invested in these two sectors.
The S&P 500 has returned nearly 90% over the past five years. That's a tough mark to beat in any market but it's even tougher when you've got 10% of your portfolio in cash.
According to Morningstar, the fund has had between 8% and 14% of the fund's assets in cash in any given year. That helps during a down market but the only downturns we've seen in the past five years have been matched with quick rebounds. With cash earning virtually nothing, that position is a dead weight for the fund.
Foreign stock exposure
Roughly a third of the portfolio has been invested overseas and that allocation has been a drag on the fund. Using the Vanguard International Stock ETF (NASDAQ:VXUS) as a very generic proxy of the international equity markets, that fund has returned a total of just 23% over the past five years. The S&P 500 returned roughly 90% during the same time frame. Keeping some of the fund invested overseas usually pays off from a risk/return standpoint over the long term but it hasn't done shareholders any favors lately.
The expense ratio
There's a reason that investors are pouring out of actively managed funds and into index funds. The cost is much lower. In a time when ETFs covering a variety of markets can be had for 10 basis points or less, the Low Priced Stock Fund sticks out for its 0.79% expense ratio.
Tillinghast has earned that fee over the long term with his outperformance, but it's worth mentioning that he'll need to continue beating his benchmark by at least 60 basis points a year in order to keep pace with an index fund. In a time when 80% of actively managed funds are failing to keep up with their benchmarks, that might be a tall order.
Breaking down the four factors listed above, I don't consider the overseas investment and the eschewal of utilities and real estate to be greatly concerning. Managers are paid to position their portfolios appropriately and they can't expected to be right all the time. Tillinghast's history shows that he's been right more often than not and deserves the benefit of the doubt.
The other two factors are more worrisome. Maintaining an expense ratio that's four times that of an index fund along with consistently keeping 10% of the fund in low-earning cash puts Tillinghast at a considerable disadvantage. If we make the assumption that equities outperform cash by about 5% a year, that's 50 basis points a year that Tillinghast is losing due to cash drag. Combine that number with the expense ratio and the fund is more than 1% in the hole against the fund's benchmark before it even gets out of the gate.
Despite Tillinghast's skill and history of strong performance, it's tough to recommend investors choose Low Priced Stock when a comparable low cost index fund is also an option.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.