A hidden small-cap fund enjoying big gains

Asia more generally has been an investment destination with great promise but mixed results in recent history. Seen as a play on strong demographics and innovation, the MSCI Emerging Markets index has made a sterling total return of just 15.4 per cent over the past five years. For context, the S&P 500 achieved a sterling total return of 88 per cent in the same period, and even the battered FTSE 250 grew by 17 per cent.

There are plenty of factors at play here, including the period having been an especially turbulent one for Chinese equities, and many emerging market funds have had mixed results.

Some funds have managed to navigate this difficult market, however – and one is a lesser-known, pint-sized option. Matthews Asia Small Companies (LU0871674379) has less than $200mn in assets, well below the market capitalisations of three dedicated Asian smaller company investment trusts: Abrdn Asia Focus (AAS), Fidelity Asian Values (FAS) and Scottish Oriental Smaller Companies (SST). The fund has stood out where it counts, however.

Analysis by the Investors' Chronicle identifying smaller funds that generate strong returns (when adjusted for the level of risk taken) has picked out Matthews Asia Small Companies for four years in a row, and its absolute performance speaks for itself. 

The fund's total five and 10-year returns are well ahead of those of its rivals in the investment trust space at 90.7 per cent and 174 per cent, respectively – even though said trusts might look appealing thanks to the fact their shares trade at discounts to portfolio net asset value (NAV).

Backing a successful open-ended fund is less likely to come with the disruptions that have plagued investment trusts, given the latter's tendency to merge with rivals as boards look to appease investors worried about persistent share price discounts.

The process

Small companies, for this fund’s purpose, are defined as those that have a market cap of less than $5bn, or less than the largest name in the fund’s key benchmark, the MSCI All Country Asia ex Japan Small Cap index – whichever is higher. The managers otherwise have a quality investment approach, and focus on firms that have strong competitive advantages achieved through pricing power, distribution capability and differentiated technologies and services. The fund also makes the most of some of the region’s biggest selling points, with the team hunting for “innovative, capital-efficient entrepreneurial companies” and preferring businesses that cater to rising domestic consumer demand.

Backing a small-cap fund that operates overseas often means encountering unfamiliar companies, and it’s worth assessing what’s currently in the portfolio. Prominent names include India’s Shriram Finance (IN:511218), which makes up 7 per cent of the portfolio and operates in areas such as commercial and personal loans. Shriram was one of the fund’s best performers in 2023, with the investment team noting that it had continued to deliver strong results and benefited from a low starting valuation. Bandhan Bank (IN:541153), another Indian name, is the fund’s second most prominent holding on a 5.2 per cent weighting.

Like many a small-cap fund, Matthews Asia Small Companies has a decent level of diversification to help combat the risky nature of its individual components. The fund has 69 holdings, and its top 10 positions make up a relatively modest 38.6 per cent of assets. Much as its top two positions seem chunky, the stock-specific risks in the fund are offset by diversification elsewhere.

Looking at sector preferences, the fund has been slightly overweight to areas including information technology, industrials, financials and healthcare versus its index. However it's on the geographic front that the team has diverged most notably from the underlying benchmark, with a chunky 31.7 per cent of the portfolio in China and Hong Kong versus 12.2 per cent for the index. This did dent returns slightly in 2023 when markets grew pessimistic about the prospects of a Chinese economic recovery, and the outlook for the country remains uncertain. 

However, there is hope that better things lie ahead. The team noted at the end of 2023, for example, that the "Asia ex Japan region contains many companies with solid business models and quality management".

"In addition, US interest rates are looking downward, which should create some macro tailwinds for the coming years. As well as the macro landscape and global trade, our focus in 2024 will be on key emerging markets that are generating robust growth, like India, and those that are challenged, like China," the team added.

Pros and cons

The fund is not immune to ups and downs, but it has certainly acquitted itself well. Even the grim sell-off of 2022 left it with a relatively limited loss of 4.2 per cent in sterling terms. Other calendar years have seen it reap big rewards, and there is no sign of the fund losing its edge. The fact that it remains fairly small means the risk of a shift in focus – for example if the team was forced to start buying bigger companies – is limited.

Investors can view this as a niche but promising play on the emerging market consumer growth story, therefore, and a fund that can quietly generate some big returns. Even if held as a relatively small position, it should be a welcome addition to many portfolios.

Because of their size, its holdings also look protected from some of the geopolitical risks that are causing problems for the most prominent emerging market stocks, including the regulatory crackdown that hit Chinese internet major Tencent (HK:700) and the trade wars that have impacted Taiwan Semiconductor Manufacturing Company (TW:2330) in the past.

The drawbacks of the fund also relate to the fact that its holdings are small, however. Matthews Asia Small Companies will not give investors exposure to the region's biggest names (such as TSMC), and it is likely to behave differently to its large-cap-focused peers. The fact that smaller company portfolios can be especially volatile at times also means that it would be best suited as a small position for most investors.

In other words, Matthews Asia Small Companies is unlikely to form the mainstay of a portfolio, but it should be a kicker for performance at a time when other markets require a little more patience.