What’s the Secret Sauce in this High-Income Fund?

Fidelity’s Adam Kramer juggles a wide variety of asset classes to produce category-leading results.

Michael Ryval 27 June, 2024 | 4:37AM
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For the past seven years, the $5.2 billion 5-star gold-medalist Fidelity Tactical High Income Sr F has been in the first or second quartile of the Tactical Balanced category. Moreover, in the last five years, and despite highly challenging markets, the fund has returned an annualized 9.45% return (as of June 24), versus 5.12% for the category.

Fidelity Tactical High Income Fund Sr F

One has to wonder, what’s the “secret sauce”? The expression is commonly used by industry participants to describe category-beating results, such as those delivered by lead manager Adam Kramer and his team.

 “There are a lot of secret sauces and many things that are different about this strategy,” says Kramer, a Boston-based portfolio manager at Fidelity Investments, a 30-year industry veteran and a chartered professional accountant who joined the firm in 2000 and currently oversees about US$32 billion in assets across a slew of funds and investment products.

Income Investing Secret Ingredient #1: Go Wide

“First and foremost, there is a flexible mandate and we can invest across a full spectrum of income-oriented asset classes. That can be anywhere from investment-grade bonds to dividend-paying stocks, and everything in the middle which most of our peers do not invest in on a regular and consistent basis.” These asset classes include investment-grade corporate bonds, U.S. high-yield bonds, U.S. floating-rate debt, convertible bonds, preferred shares in the U.S. and Canada, emerging market debt, real estate investment trusts, and global infrastructure stocks.

Income Investing Secret Ingredient #2: Be Flexible

The second key ingredient is the fund’s flexibility to preserve capital in down markets. “It also allows you to do more with less,” says Kramer, a Montreal native who earned an MBA in 2000 from the Cornell Johnson Graduate School of Management. Other team members on the fund include long-time portfolio managers Ramona Persaud and Ford O’Neil. Essentially, the team preserves capital by earning a so-called premium yield that dampens the effects of falling markets, but also works by earning equity-like returns in rising markets.

Income Investing Secret Ingredient #3: Match Your Bonds and Stocks

Most of all, Kramer credits the skillful matching of bonds and stocks as part of their process. “Most funds with 60/40, 50/50, or 40/60 blends just don’t have enough income to fully dampen the blows in a down market. That is something that we are constantly toggling, or adjusting,” says Kramer, noting that the fund was launched in May 2014. This is reflected in the fund’s performance, which has placed it in the first percentile against 110 funds in the last 10 years and in the third percentile against 245 funds over the last five years. As of May 22, the fund is also available as an exchange-traded fund, Fidelity Tactical High Income, or FTHI.

Asset Class Returns Will ‘Take Turns’

 “If you look at the total returns of major income-oriented asset classes in the U.S.—such as investment-grade bonds—each asset class takes turns as the best and worst-performing asset in a given year. And the difference is often thousands of basis points. Unlike the last two-and-half years, where the S&P 500 Index has been the best-performing asset class and U.S. investment-grade bonds have been the worst, if you look over the last two-and-a-half decades, you will notice that a majority of the time, something other than the S&P 500 and U.S. investment grade bonds are the best-performing asset classes. So being able to look at these areas on a regular and consistent basis allows us to really find those tools to ‘do more with less,’” says Kramer, who works within Fidelity’s High Income and Alternatives group, which oversees about US$100 billion in assets and is supported by more than 50 research professionals who study a slew of asset classes. 

“Our High Income & Alternative analysts are skilled in analyzing corporate credit, which may include the entire capital structure of a company,” argues Kramer. “These may include high yield bonds, floating rate debt, convertible bonds and preferred shares; parts of the balance sheet which I like to call “the super asset classes”, because of their proper matching of income to the amount of risk being assumed in the bond or equity markets. Our analysts are looking at these companies from a bottom-up perspective, and asking themselves, ‘Where is the best risk-reward in the capital structure of an issuer?’ Then they put a buy or sell rating on them for our internal purposes. I will look at these reports and speak to the analysts as a way to determine where the best opportunities are for the funds I manage.”

Despite a relatively high turnover ratio of 221%, which is largely due to the use of U.S. treasuries, the fund generates a pre-expenses yield of 4.5%, and is produced in a tax-aware manner, says Kramer.

Balanced Fund Alternative with a Twist

The fund was created a decade ago in response to investors’ demands, Kramer notes. We have a lot of asset allocation funds and I manage a bunch,” he says, noting that he also oversees the $99.3 million 4-star gold-medalist Fidelity Strategic Income Fund F. “Our investors wanted something with more flexibility, and with all these characteristics that I’ve mentioned. But they also wanted the lead manager to have the fiduciary responsibility to choose the best ideas from each one of the asset classes, with the direct input of the co-managers. We are offering an alternative to a balanced fund---but with premium yield characteristics, proper matching, and a ‘best ideas’ perspective. That ability to choose securities—with ten to 50 best ideas of each asset class, as opposed to rolling the money out to various managers---and that nimbleness, to adjust to different assumptions in the market, has allowed us to achieve our objectives of capital preservation in down markets, premium yield and capital appreciation when markets turn up again.”

Kramer argues that his team’s approach is somewhat different from other teams that manage tactical balanced funds. He points to key team members such as Persaud, who offers her expertise on equities, plus O’Neil is an expert on investment-grade bonds. Scott Mensi is an institutional portfolio manager who specializes in credit, as well as himself, since he manages multi-credit portfolios, convertible bonds, and preferred stock funds. “When you put the four of us in the room, what is different is that you have the full spectrum of income-oriented asset classes represented and with expertise on where things should be through the cycles. Each one of us is choosing securities for our respective single-asset class funds, so we are coming in with our best ideas. That’s what makes our team unique since you have a full spectrum of asset classes represented.”

While the fund has proven itself over most time periods, and the process is constantly improving, Kramer admits that 2017 proved to be disappointing. That was when it produced a fourth quartile result and returned -1.20%, versus 6.96% for the category.

The Opportunity Cost of Lower Risk

“In 2017, we didn’t have enough equities in the fund, and we didn’t have enough of the largest names in the S&P 500 Index,” says Kramer, noting that the fund’s mandate is to have between 30% and 60% in equities. It was in 2017 when we didn’t have the same risk profile that wiggles around the traditional 50-50 benchmark that the investors wanted. That was a humbling period because in 2017 we were making some predictions, but that’s where we really changed the process. At the end of 2017, we decided to focus on letting the opportunities come our way, and make sure that we had enough income to dampen the blows in a down market and continue to focus on finding our best ideas.

The team also put a limit on how big the so-called underweight positions in stocks in the S&P 500. “As part of the changes implemented in 2017, we now force ourselves to own the biggest names in the index. That’s why you see names like Apple Inc. (AAPL), NVIDIA Corp. (NVDA) and Alphabet Inc. (GOOG), albeit we would be considered very underweight relative to a traditional balanced fund. During the 2017 period, not having a limit on how large an underweight to the largest names in the S&P500 was the biggest error we had made.”

The key to the fund’s strategy has been flexibility in asset class weightings. For instance, at the end of September 2023, when interest rates were almost sky-high, the fund held 43.3% in foreign bonds, 19.2% U.S. high yield bonds, 31.8% foreign (mostly US) and Canadian equities and 3.8% convertibles. As of March 31, when the environment shifted once more, the fund rotated into stocks, with a 44.7% weighting, plus 46.8% in bonds and 8.38% in a mix of convertible and preferred shares.    

“Most of the time risk is priced in different ways than what we expect it to. The narrative is always different,” says Kramer. “Some of the areas that sold off along with bonds were also stocks and convertible bonds and a lot of preferred shares. It was in areas that you least expected. But it was more about looking where the best opportunities were.” 

Best Dividend Paying Stock Opportunities

Indeed, Kramer adds, while many asset classes were pricing in a recession, credit markets did not price in that scenario—with the result that they did relatively well.  “Even though many asset classes priced in recession and that real yields would keep going higher, it turned out that credit markets never priced that in,” says Kramer. “So, there were fewer opportunities in areas you would have expected to offer opportunities. Instead, the areas that presented opportunities were in fixed-to-floating preferred shares and some of the equities, such as in dividend-paying oil tankers, energy, food, and large-cap pharmaceutical companies.”

Currently, and based on the April 30 fund profile (the most recent date for compliance purposes), about 36% of the portfolio is held in investment-grade U.S. bonds, plus about 11% in U.S. high-yield bonds.  “If you own the seven-year U.S. treasury bond, for instance, it has a 4% current yield and a six-year duration. If rates go up 100 basis points, or down, that’s a plus 10% upside or -2% downside risk-reward profile. That’s extremely attractive in a world where we would probably be in a 4% range [for the Fed funds rate]. That’s until something changes in the economy. If the economy weakens, or if there is a shock, or if inflation does come down, then you may see a world where the bank rate goes below 4%.” Otherwise, there is an underweighted 45% in equities (which is primarily in stocks and 3% convertible bonds), plus 12% in a combination of high-yield bonds, bank loans, emerging market debt, and preferred shares. 

Don’t Predict - Hedge Instead

As for expectations of where the trend-setting Federal Reserve may go next, and how it may influence markets, Kramer refuses to make any predictions. “One of the great things about the process is that we can recognize where we are and understand that how inflation is calculated. But we are not trying to make any predictions,” observes Kramer. “It all goes back to where can we get the best risk-reward and where we can get an equity-like return if things work out. But if things don’t work out, then we are still dampening the blows in a down market.”

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Fidelity Strategic Income Fund F9.94 CAD0.20Rating
Fidelity Tactical High Income Sr F15.81 CAD0.60Rating

About Author

Michael Ryval

Michael Ryval  is a regular contributor to Morningstar. He is a Toronto-based freelance writer who specializes in business and investing.

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