The trust was launched in April 2010 by star manager Anthony Bolton, who had become a household name during his successful tenure as manager of Fidelity’s flagship Special Situations fund. In June 2013 however, following a difficult few years where the closed-ended fund struggled against its benchmark, Bolton announced his retirement.
He was replaced by Dale Nicholls of the offshore FF Pacific fund in April this year.
Although Elliott says that Nicholls’ appointment did come as a surprise, he doesn’t doubt the manager’s ability to outperform over the long-term. However, he still has a number of concerns about Fidelity China Special Situations.
“The transition between Anthony Bolton and Dale Nicholls was well sign-posted,” Elliott (pictured) said.
“However, we remain sceptical as to whether Fidelity has sufficient resources at present to manage a highly specialist mid and small cap Chinese equities portfolio. The dedicated analyst that previously supported Anthony Bolton has left the firm and a replacement has yet to be found.”“Use is still made of third party experts to provide verification of management claims but that only underlines the difficulties in investing in the lower end of the market.”
The trust differs from the large majority of other China portfolios in that Nicholls, like Bolton before him, has a clear bias towards mid and small cap companies.
Although Elliott says it is admirable that Nicholls hasn’t changed the investment focus, he questions the manager’s expertise in this part of the market.
“The new manager’s familiarity with a number of the portfolio holdings is open to question,” he continued.
“He has met the majority of them but his experience of some of these companies will be limited. A lot of store is placed on Fidelity’s extensive bank of analysts and its increasing resources in Shanghai.”
“However, these are not small cap specialists and their coverage of these lower profile companies will be patchy.”
According to FE Analytics, the £653m Fidelity China Special Situations trust has returned 8.78 per cent since its launch in April 2010, beating its MSCI China index benchmark by 4.11 percentage points.
Performance of trust vs index since Apr 2010
Source: FE Analytics
The trust has struggled against the index over the past few years, which is partly a reflection of Bolton’s value/contrarian style and the fact that it has a high weighting to small and mid caps.
Although it is a very short period of time, the trust's returns of 2.86 per cent since April mean it is also down against the index since Nicholls took over.
Performance of trust vs index since Apr 2014
Source: FE Analytics
A spokesperson from Fidelity says that Nicholls and his team’s experience means that shareholders in the trust are in good hands.
“Dale has proven successful in generating investment returns from Chinese companies, particularly in the small and mid cap space and knows this market in depth,” the spokesperson said.
“Dale also brings a regional perspective to the company and is well placed to compare Chinese companies and China’s economic development to regional peers, helping to ensure only the strongest ideas find their way into the portfolio.”
They also point out that Nicholls has the support of 12 China analysts based in Hong Kong and Shanghai, as well as another 31 regional analysts who also cover Chinese companies.
Nicholls has managed the $1.6bn, five crown-rated FF Pacific fund since September 2003. It has returned 180.77 per cent over this time, beating its benchmark – the MSCI AC Pacific index – by more than 50 percentage points.
Performance of fund vs index since Sep 2003
Source: FE Analytics
Elliott and his team at Winterflood aren’t completely writing Fidelity China Special Situations off, despite their concerns.
“We believe that Fidelity China Special Situations remains an interesting, valid mandate,” Elliott said.
“A stock-driven portfolio focused on growing Chinese consumerism through exposure to mid and small cap companies is, in our view, a valid, albeit highly specialist and risky mandate. The potential to make considerable returns is there and our expectation is that the fund will outperform in strong market conditions.”
However, Elliott says that the high amounts of leverage used within the portfolio mean it is only suitable for certain risk-on investors
“We believe that the level of gearing, around 22 per cent at present, adds substantial risk to the fund. In addition, the manager’s use of hedging provides a layer of complexity and dilutes the fund's investment message,” he said.
“Although we would expect the fund to perform strongly in a bull market, due to its gearing and mid/small cap bias, we would question its suitability for retail investors that make up the bulk of its shareholder base.”
The Fidelity spokesperson says the trust’s current level of gearing is a reflection of the manager’s bullish outlook, as he thinks the current market is undervalued.
Fidelity China Special Situations is currently trading on a 10 per cent discount, which is wider than its one and three year average. However, it has been on a 13 per cent discount to NAV at times over the past 12 months.
Elliott questions why the trust’s board hasn’t exercised its right to offer shareholders a tender offer for up to 15 per cent of the shares in issues at a 5 per cent discount. He says this is something he has discussed in the past, but that the board said it would only buy back shares when Nicholls has had time to adapt to his new role.
Elliott says this decision doesn't make much sense.
“Although we are wary of simply offering liquidity when asset classes are out of favour, as China clearly is at the moment, the far bigger issue here is that many investors in the fund bought Bolton first, China second,” he said.
“Therefore, there was always likely to be significant numbers seeking an exit on his retirement.”
“By not immediately producing plans to hold a tender, the fund’s discount was always likely to widen despite buybacks. Given the high level of retail ownership, in our view, it is essential that the board is proactive in guarding the interests of its shareholders, particularly the smaller ones.”
The board recently took the decision to lower the base management fee from 1.2 per cent to 1 per cent and reduced the performance fee from 1.5 per cent to 1 per cent.
Fidelity China Special Situations now has ongoing charges, plus a performance fee, of 2.43 per cent.
