Objective and Strategy

MAINX seeks total return over the long term with an emphasis on income. The fund invests in income-producing securities which will include government, quasi-governmental and corporate bonds, dividend-paying stocks and convertible securities (a sort of stock/bond hybrid).  The fund may hedge its currency exposure, but does not intend to do so routinely.  In general, at least half of the portfolio will be in investment-grade bonds.  Equities, both common stocks and convertibles, will not exceed 20% of the portfolio.

Adviser

Matthews International Capital Management. Matthews was founded in 1991.  As of December 31, 2011, Matthews had $15.3 billion in assets in its 13 funds.  On whole, the Matthews funds offer below average expenses. Over the past three years, every Matthews fund has above-average performance except for Asian Growth & Income (MACSX). They also publish an interesting and well-written newsletter on Asian investing, Asia Insight.

Manager(s)

Teresa Kong is the lead manager.  Before joining Matthews in 2010, she was Head of Emerging Market Investments at Barclays Global Investors (now BlackRock) and responsible for managing the firm’s investment strategies in Emerging Asia, Eastern Europe, Africa and Latin America. In addition to founding the Fixed Income Emerging Markets Group at BlackRock, she was also Senior Portfolio Manager and Credit Strategist on the Fixed Income credit team.  She’s also served as an analyst for Oppenheimer Funds and JP Morgan Securities, where she worked in the Structured Products Group and Latin America Capital Markets Group.  Kong has two co-managers, Gerald Hwang, who for the past three years managed foreign exchange and fixed income assets for some of Vanguard’s exchange-traded funds and mutual funds, and Robert Horrocks, Matthews’ chief investment officer.

Management’s Stake in the Fund

Every member of the team is invested in the fund, but the extent – typically substantial at Matthews – is not yet disclosed.

Opening date

November 30, 2011.

Minimum investment

$2500 for regular accounts, $500 for IRAs.  The fund’s available, NTF, through Fidelity, Vanguard, Scottrade and a few others.

Expense ratio

1.0%, after waivers, on $19 million in assets (as of 2/23/12).  That’s a 40 basis point decline from opening expense ratio. There’s also a 2% redemption fee for shares held fewer than 90 days.

Comments

With the Federal Reserve’s January 2012 announcement of their intent to keep interest rates near zero through 2014, conservative investors are being driven to look for new sources of income.  Ms. Kong highlights a risk the bond investors haven’t previously wrestled with: shortfall risk.  The combination of microscopic domestic interest rates with the slow depreciation of the U.S. dollar (she wouldn’t be surprised at a 2% annual loss against a basket of foreign currencies) and the corrosive effects of inflation, means that more and more “risk-free” fixed-income portfolios simply won’t meet their owners’ needs.  Surmounting that risk requires looking beyond the traditional.

For many investors, Asia is a logical destination.  Three factors support that conclusion:

1. Asian governments and corporations are well-positioned to service their debts.  On whole, debt levels are low and economic growth is substantial.  Haruhiko Kuroda of the Asian Development Bank projected (in late January 2012) that Asian economies — excluding Japan, Australia and New Zealand — to grow by around 7% in 2012, down from about 7.5% in 2011 and 9% in 2010.  France, by contrast, projects 0.5% growth, the Czech Republic foresees 0.2% and Germany, Europe’s soundest economy, expects 0.7%.
   This high rate of growth is persistent, and allows Asian economies to service their debt more and more easily each year.  Ms. Kong reports that Fitch (12/2011) and S&P (1/2012) both upgraded Indonesian debt, and she expects more upgrades than downgrades for Asia credits.
2. Most Asian debt supports infrastructure, rather than consumption.  While the Greeks were borrowing money to pay pensions, Asian governments were financing roads, bridges, transport, water and power.  Such projects often produce steady income streams that persist for decades, as well as supporting further growth.
3. Most investors are under-exposed to Asian debt markets.  Bond indexes, the basis for passive funds and the benchmark for active ones, tend to be debt-weighted; that is, the more heavily indebted a nation is, the greater weight it has in the index.  Asian governments and corporations have relatively low debt levels and have made relatively light use of the bond market.

Ms. Kong illustrated the potential magnitude of the underexposure.  An investor with a global diversified bond portfolio (70% Barclays US Aggregate bond index, 20% Barclays Global Aggregate, 10% emerging markets) would have only 7% exposure to Asia.  However you measure Asia’s economic significance (31% of global GDP, rising to 38% in the near future or, by IMF calculations, the source of 50% of global growth), even fairly sophisticated bond investors are likely underexposed.

The European debt crisis, morphing into a banking crisis, is making bank loans harder to obtain.  Asian borrowers are turning to capital markets to raise cash.  Asian blue chip firms issued $14 billion in bonds in the first two months of 2012, in a development The Wall Street Journal described as a “stampede” (02/23/12). The market for Asian debt is becoming larger, more liquid and more transparent.  Those are all good things for investors.

The question isn’t “should you have more exposure to Asian fixed-income markets,” but rather “should you seek exposure through Matthews?”  The answer, in all likelihood, is “yes.”   Matthews has the largest array of Asia investment products in the U.S. market, the deepest analytic core and the broadest array of experience.  They also have a long history of fixed-income investing in the service of funds such as Matthews Asian Growth & Income (MACSX).   Their culture and policies are shareholder-friendly and their success has been consistent.

Asia Strategic Income will be their first income-oriented fund.  Like FPA Crescent (FPACX) in the U.S. market, it has the freedom range across an entity’s capital structure, investing in equity, debt, hybrid or derivative securities depending on which offers the best returns for the risk.  The manager argues that the inclusion of modest exposure to equities will improve the fund’s performance in three ways.

1. They create a more favorable portfolio return distribution.  In essence, they add a bit more upside and the manager will try “to mitigate downside by favoring equities that have relatively low volatility, high asset coverage and an expected long term yield higher than the local 10 year Treasury.”
2. They allow the fund to exploit pricing anomalies.  There are times when one component of a firm’s capital structure might be mispriced by the market relative to another. .  Ms. Kong reports that the fund bought the convertible shares of an “Indian coal mining company.  Its parent, a London-listed natural resource company, has bonds outstanding at the senior level.  At the time of purchase, the convertibles of the subsidiary offered higher yield, higher upside than the parent’s bonds even though the Indian coal mining had better fundamentals, less leverage, and were structurally senior since the entity owns the assets directly.”
3. They widen the fund’s opportunity set.  Some governments make it incredibly difficult for foreigners to invest, or invest much, in their bonds.  Adding the ability to invest in equities may give the managers exposure to otherwise inaccessible markets.

Unlike the indexes, MAINX will weight securities by credit-worthiness rather than by debt load, which will further dampen portfolio risk.  Finally, the fund’s manager has an impressive resume, she comes across as smart and passionate, and she’s supported by a great organization.

Bottom Line

MAINX offers rare and sensible access to an important, under-followed asset class.  The long track record of Matthews’ funds suggests that this is going to be a solid, risk-conscious and rewarding vehicle for gaining access to that class.  Despite the queasiness that conservative investors, especially, might feel about investing what’s supposed to be their “safe” money overseas, there’s a strong argument for looking carefully at this as a supplement to an otherwise stagnant fixed-income portfolio.

Fund website

Matthews Asia Strategic Income