At the time of publication, this fund was named Osterweis Strategic Investment.

Objective and strategy

The fund pursues the reassuring objective of long-term total returns and capital preservation. The plan is to shift allocation between equity and debt based on management’s judgment of the asset class which offers the best risk-return balance. Equity can range from 25 – 75% of the portfolio, likewise debt. Both equity and debt are largely unconstrained, that is, the managers can buy pretty much anything, anywhere. That means that the fixed-income portfolio might at one point contain a large exposure to high-yield securities and, at another, to Treasuries. The two notable restrictions are minor: no more than 50% of the total portfolio can be invested outside the U.S. and no more than 15% may be invested in Master Limited Partnerships, which are generally energy and natural resources investments.

Adviser

Osterweis Capital Management. Osterweis Capital Management was founded in 1983 by John Osterweis to manage money for high net worth individuals, foundations and endowments. They’ve got $10 billion in assets under management (as of December 31, 2015), and run both individually managed portfolios and four mutual funds. Osterweis once managed hedge funds but concluded that such vehicles served their investors poorly and so wound them down in 2012. (Their argument is recapped in the “Better Mousetrap” article, linked below.) The firm is privately-held, mostly by its employees. Mr. Osterweis is in his early 70s and, as part of the firm’s transition plan, has been transferring his ownership stake to a cadre of key employees. At least six of the eight co-managers listed below own 5% of more of the adviser.

Managers

John Osterweis, Matt Berler and Carl Kaufman lead a team that includes the folks (John Osterweis, Matthew Berler, Alexander “Sasha” Kovriga, Gregory Hermanski, and Nael Fakhry) who manage Osterweis Fund (OSTFX) and those at the Osterweis Strategic Income Fund (Carl Kaufman, Simon Lee and Bradley Kane). The equity team manages over 300 separate accounts; the fixed-income team handles “a small number” of them. The team members have all held senior positions with distinguished firms (Robertson Stephens, Morgan Stanley, and Merrill Lynch).

Strategy capacity and closure

Mr. Kaufman was reluctant to estimate capacity since it’s more determined by market conditions (“in 2008 we could have put $50 billion to work with no problem”) than by limits on the asset classes or team. Conservatively estimated, the fixed-income team could handle at least an additional $4 billion given current conditions.

Active share

“Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. Typically active share is calculated only for equity funds, so we do not have a calculation for OSTVX. The equity sleeve of this fund is the same as the flagship Osterweis Fund (OSTFX), whose active share is 94 which reflects a very high level of independence from its benchmark.

Management’s stake in the fund

Four of the eight team members had investments in excess of $1 million in the fund, a substantial increase since our last profile of the fund. The four younger members of the team generally have substantial holdings. As of December 31, 2013, none of the fund’s independent trustees (who are very modestly compensated for their work) had an investment in the fund. Two of the five had no investment in any of the Osterweis funds they oversee.

Opening date

August 31, 2010

Minimum investment

$5000 for regular accounts, $1500 for IRAs and other tax-advantaged accounts.

Expense ratio

0.97% on assets of $166.6 million (as of July 18, 2023).

Comments

Explanations exist; they have existed for all time; there is always a well-known solution to every human problem — neat, plausible, and wrong. H.L. Mencken, “The Divine Afflatus,” New York Evening Mail, 16 Nov 1917.

If you had to invest in a portfolio that held a lot of fixed-income securities which of the following would you prefer, a fund that’s “more conservative than the portfolio’s credit profile suggests,” which “shines when volatility is considered” and its “lowest 10-year Morningstar Risk score” or one that suffers from “a lack of balance,” is “one-sided,” “doubles down on related risks” and “is vulnerable to contractions”?

Good news! You don’t have to choose since those excerpts, all from Morningstar analyst Kevin McDevitt’s latest analyses, describe the exact same portfolio: Osterweis Strategic Income (OSTIX), which serves as the fixed-income portion of the Osterweis Strategic Investment Fund’s portfolio.

How does the same collection of fixed-income securities end up being praised for their excellent low risk score and being pilloried for their riskiness? Start with the dogmatic belief that “investment grade” is always safe and good and that “high yield” is always dangerous and bad. Add in the assumption that the role of fixed-income in a stock/bond hybrid “is to provide ballast” and you’ve got a recipe for dismissing funds that don’t conform to the cookie-cutter.

Neither assumption is universally true which is to say, neither should be used as an assumption when you’re judging your investments.

Is high-yield always riskier than investment grade?

No.

There are two sources of risk to consider: interest-rate risk and credit risk. Investment grade bond investors thrive when interest rates are falling; they suffer loss of principal when interest rates rise. The risk is systemic: all sorts of intermediate-term bonds are going to suffer about equally when the Feds raise rates. Fed funds rate futures are currently forecasting a 50% prospect of a 0.25% rate hike in April and an equal chance of a 0.50% hike by October. Credit risk, the prospect that a bond issuer won’t be able to repay his debt, is idiosyncratic. That is, it’s particular to individual issuers and it’s within the power of fund managers to dodge it. In a strengthening economy, interest rate risks rise and credit risk falls. Because ratings agencies under-react to changing conditions, companies and entire sectors of the economy might have substantially lower credit risk than their “non-investment grade” ratings imply. Mr. Kaufman, one of the managers, reports on the case of “one firm in the portfolio which cut its outstanding debt in half, has lots of free cash flow and was still belatedly downgraded.” Likewise, the debt of energy companies was rated as investment grade while the sector was imploding; now that it has likely bottomed, it’s being reclassified as junk.

The Osterweis team argues that it’s possible to find lots of opportunities in shorter term high yield debt, in particular of companies that are fundamentally stronger than outdated ratings reports recognize. Such firms, Mr. Kaufman argues, offer the best risk-return tradeoff of any fixed income option today:

We invest in fixed-income for absolute return. We’re playing chicken right now, betting that interest rates won’t rise just yet. When the music stops, people are going to get hurt. I don’t like to make bets. I want to control what I can control. Investment grade investors win only if interest rates go lower. Look at what’s going to happen if nothing happens. The yield on the 10-year Treasury is 1.673%. That’s what you would get for returns if nothing happens.

Is fixed-income always the portfolio’s ballast?

No.

There are, broadly speaking, two sorts of funds which mix both stocks and bonds in their portfolios. One sort, often simply called a “balanced” fund, sticks with a mix that changes very little over time: 60% stocks (mostly domestic large caps) plus 40% bonds (mostly investment grade), and we’re done. They tend to be inexpensive, predictable and reassuringly dull. An excellent anchor for a portfolio, at least if interest rates don’t rise.

The second sort, sometimes called an “allocation” fund, allows its manager to shift assets between and within categories, sometimes dramatically. These funds are designed to allow the management team to back away from a badly overvalued asset class and redeploy into an undervalued one. Such funds tend to be far more troubled than simple balanced funds for two reasons. First, the manager has to be right twice rather than once. A balanced manager has to be right in his or her security selection. An allocation manager has to be right both on the weighting to give an asset class (and when to give it) and on the selection of stocks or bonds within that portion of the portfolio. Second, these funds can carry large visible and invisible expenses. The visible expenses are reflected in the sector’s high expense ratios, generally 1.5 – 2%. The funds’ trading, within and between sectors, invisibly adds another couple percent in drag though trading expenses are not included in the expense ratio and are frequently not disclosed.

Why consider these funds at all?

If you believe that the market, like the global climate, seems to be increasingly unstable and inhospitable, it might make sense to pay for an insurance policy against an implosion in one asset class or one sector. One is to seek a fund designed to dodge and weave through the hard times. If the manager is good (see, for example, Rob Arnott’s PIMCO All Asset PASDX, Steve Romick’s FPA Crescent FPACX or Leuthold Core LCORX) you’ll receive your money’s worth and more. Another option would be to use the services of a good fee-only financial planner who specializes in asset allocation. In either case, you’re going to pay for access to the additional “dynamic allocation” expertise.

Why consider Osterweis Strategic Investment?

There are two reasons. First, Osterweis makes sense in an uncertain world. Osterweis Strategic Investment is essentially the marriage of the flagship Osterweis Fund (OSTFX) and Osterweis Strategic Income (OSTIX). OSTFX is primarily a stock fund, but the managers have the freedom to move decisively into bonds and cash if need be. In the last 10 years, the fund’s lowest stock allocation was 60% and highest was 96%, but it tends to have a neutral position in the upper-80s. Management has used that flexibility to deliver solid long-term returns (7.3% over the past 15 years, as of 1/21/2015) with a third less volatility than the stock market’s. Osterweis Strategic Income (OSTIX) plays the same game within the bond universe, moving between bonds, convertibles and loans, investment grade and junk, domestic and foreign. This plays hob with its long-term rankings at Morningstar, which has placed it in three very different categories (convertibles, multi-sector income and high-yield bonds) over the past 10 years but now benchmarks all of its trailing returns as if it had been a high-yield bond fund all along.

For now, the fund is dialing back on its stock exposure. Mr. Kaufman reports:

We can invest 75%/25% in either direction. Our decision to lighten up on stocks now – we’ve dropped near 60% – determined by opportunity set. We’re adding fixed income now because we’re finding lots of great value in the short-term side of the market. Equities might return 6% this year and we think we can get equity-like returns, without equity-like risk, in fixed-income portfolio.

In his recent communication with shareholders, he writes:

We prefer to add risk only when we see a “fat pitch,” of which there are precious few at this time … at current yields there is no investment grade “fat pitch.” Our focus remains on keeping duration short and layering-in higher yielding paper, especially on sharp corrections in the market like we have seen recently. We believe that the appropriate time to take a swing at investment grade bonds will be when yields are much higher and the economy is teetering towards recession.

Second, Osterweis’s expenses, direct and indirect, are more reasonable than most. The 1.15% ratio (as of the most recent prospectus) has been dropping steadily and is at the lower end for an active allocation fund, strikingly so for a tiny one. And the other two Osterweis funds each started around 1.5% and then steadily lowered their expense ratios, year after year, as assets grew. In addition, both funds tend to have lower-than-normal portfolio turnover, which decreases the drag created by trading costs.

Bottom Line

It is easy to dismiss OSTVX because it refuses to play by other people’s rules; it rejects the formulaic 60/40 split, it refuses to maintain a blind commitment to investment grade bonds, its stock sector-, size- and country-weightings are all uncommon. Because rating systems value herd-like behavior and stolid consistency, these funds may often look bad. The question is, are such complaints “neat, plausible and wrong”? The fund’s fixed income portfolio have managed a negative down-market capture over the past 12 years; that is, it rises when the bond market falls, then rises some more when the bond market rises. Osterweis closed down their hedge fund business, concluding that many investors would derive much more benefit, more economically, from using a balanced fund as a significant part of their portfolio. Given reasonable expenses, outstanding management and a long, solid track record, Osterweis Strategic Investment warrants a place on any investor’s due-diligence short list.

Fund website

Osterweis Growth & Income Fund. There’s a link to a really nicely-reasoned, well-written piece on why, to be blunt, hedge funds are stupid investments. Osterweis used to run one and concluded that they could actually serve their investors better (better risk/return balance, less complexity, lower expenses) by moving them to a balanced fund. 

Objective and strategy

The managers pursue long-term growth of capital and income by investing in a fairly compact portfolio of international small cap stocks. Their goal is to find the most undervalued streams of sustainable cash flow that they can. The managers start with quantitative screens to establish country and industry rankings, then a second set of valuation screens to identify a pool of potential buys. There are around 17,000 unique companies between $50 million – $3 billion in market cap. Around 400 companies have been passing the screens consistently for the past many months. Portfolio companies are selected after intensive fundamental review. The portfolio typically holds between 75-100 stocks representing at least 10 countries.

Adviser

Pear Tree Advisors is an affiliate of U.S. Boston. U.S. Boston was founded in 1969 to provide wealth management services to high net worth individuals. In 1985, they began to offer retail funds, originally under the Quantitative Funds name, each of which is sub-advised by a respected institutional manager. There are six funds in the family, two domestic (U.S. large cap quality and U.S. small cap) and four international (international multi cap value, international small cap value, and two emerging markets funds). The sub-adviser for this fund is Polaris Capital Management, LLC. Founded in 1995, Polaris describes itself as a “global value equity manager.” The firm is owned by its employees and, as of December 2014, managed $5.6 billion for institutions, retirement plans, insurance companies, foundations, endowments, high-net-worth individuals, investment companies, corporations, pension and profit sharing plans, pooled investment vehicles, charitable organizations, state or municipal governments, and limited partnerships.

Manager

Bernard Horn, Sumanta Biswas and Bin Xiao. Mr. Horn is Polaris’s founder, president, chief investment officer and lead manager on Polaris Global Value Fund. He is, on whole, well-known and well-respected in the industry. Day to day management of the fund, including security selection and position sizing, is handled by Messrs. Biswas and Xiao. Mr. Biswas joined the firm as an intern (2001), was promoted to research analyst (2002), then assistant portfolio manager (2004), vice president (2005) and Partner (2007). Mr. Xiao joined the firm as an analyst in 2006 and was promoted to assistant portfolio manager in 2012. Both are described as investment generalists. The team manages about $5.6 billion together, including the Polaris Global Value Fund (PGVFX) and subadvisory of PearTree Polaris Foreign Value (QFVOX) the value portion of PNC International Equity (PMIEX), and other multi-manager funds.

Strategy capacity and closure

Between $1 – 1.5 billion, an amount that might rise or fall as market conditions change. The number of international small cap stocks is growing, up by nearly 100% in the past decade and the number of international IPOs is growing at ten times the U.S. rate. 

Size constraint is ‘time’ dependent.  The Fund objective is to beat the benchmark with lower than benchmark risk (risk is the ITD annualized beta of the portfolio). The managers’ past experience suggests that a portfolio of around 75-100 stocks provides an acceptable risk/return trade-off. Overlaying a liquidity parameter allowed the Fund to reach the $1- $1.5 billion in potential assets under management. 

However the universe of companies is expanding and liquidity conditions keep changing. Fund managers suggested that they are open to increasing the number of companies in the portfolio as long as the new additions do not compromise their risk/return objective. So, the main constraining factor guiding fund size is how many investable companies the market is offering at any given point in time.  

Active share

“Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. The advisor has not calculated the active share for its funds but the managers note that the high tracking error and low correlation with its benchmark implies a high active share.

Management’s stake in the fund

Mr. Horn has over $1 million in the fund and owns about 5% of the fund’s institutional shares. Messrs. Xiao and Biswas each have been $50,000-100,000 invested here; “we have,” they report, “all of our personal investments in our funds.” Three of the four independent trustees have no investment in the fund; one of them has over $100,000.

Opening date

May 1, 2008.

Minimum investment

$2,500, reduced to $1,000 for tax-advantaged accounts. The institutional minimum is $1 million. Roger Vanderlaan, one of the Observer’s readers, reports that the institutional shares of this fund, as well as the two others sub-advised by Polaris for Pear Tree, are all available from Vanguard for a $10,000 initial purchase though they do carry a transaction fee.

Expense ratio

1.04% on assets of $995.3 million for the institutional class shares, 1.41% for investor class shares, as of July 2023. 

Comments

There are three, and only three, great international small cap funds: Wasatch International Opportunities (WAIOX), Grandeur Peak International Opportunities (GPIOX) and Pear Tree Polaris Foreign Value Small Cap.

What do we mean by “small cap”? We looked for funds that invested in (brace yourselves) small and micro-cap stocks. One signal of that is the fund’s average market cap; we targeted funds at $2 billion or less since about 80% of all stocks are below that threshold. Of the 90 funds in the Morningstar’s international small- to mid-cap categories, only 17 actually had portfolios dominated by small cap stocks.

What do we mean by “great”? We started by looking at the returns of those 17 funds over the past one-, three- and five-year periods. Two things were clear: the same names dominated the top four spots over and over and only three funds managed to make money over the past year (through the end of January, 2015). And the fourth fund, Brandes International Small Cap Equity “A”(BISAX) looked strong except (1) it sagged over the past year and (2) the great bulk of its track record, from inception in August 1996 through January 2012, occurred when it was organized as “a private investment commingled fund.” The SEC allowed BISAX to assume the performance record of the prior fund, but questions always arise when an investment vehicle moves from one structure to another.

(all returns are through January 30, 2015)

That’s leads to two questions: should you consider adding any international small cap exposure to your portfolio? And should you especially consider adding Pear Tree Polaris to it? For many investors, the answer to both is “yes.”

Why international small cap?

There are four reasons to consider adding international small cap exposure.

1. They are a large opportunity set. About 80% of the world’s stocks have market caps below $2 billion. Grandeur Peak estimates that there are 29,000 investible small cap stocks worldwide, 25,000 being outside of the U.S.
2. The opportunity set is growing. Since 2000, over 90% of IPOs have been filed outside of the US. Meanwhile, the number of US listed stocks declined from 9,000 to under 5,000 in the first 12 years of the 21stcentury. As markets deepen and the middle class grows in many emerging nations, the number of small caps will continue to climb.
3. You’re ignoring them, and so is almost everyone else. As we noted above, there are fewer than 20 true international small cap funds. Most of the funds that bear the designation actually invest most of their money into mid-caps and often a lot into large caps as well. According to Morningstar, the average small- to mid-cap international growth fund has 24% of its money in small caps and 19% in large caps. International small value and blend funds invest, on average, 35-38% in small caps. Broad international indexes have only 3-4% of their weightings in small caps, so those won’t help you either. Given that the average individual US investor has an 80% allocation to US stocks, it’s likely that you have under 1% of your portfolio in international small caps.
4. They are a valuable opportunity set. There are three factors that make them valuable. They are independent: they are weakly correlated with the US market, international large caps or each other, they are rather state-owned and they are driven more by local conditions than by government fiat or global macro trends. They are mispriced. Because of liquidity constraints, they’re ignored by large institutions and index-makers. The average international microcap is covered by one analyst, the average small cap by four, and 20% of international small caps have no analyst coverage. Across standard trailing time periods, they outperform international large caps with higher Sharpe and Sortino ratios. Finally, they are the last, best haven of active management. The average international small cap manager outperforms his or her benchmark by 200-300 bps. Really good ones can add a multiple of that.

Why Pear Tree Polaris?

While this fund is relatively new, the underlying discipline has been in place for 30 years and has been on public display in Polaris Global Value Fund (PGVFX) for 17 years.  The core strategy is disciplined, simple and repeatable. They’re looking to buy the most undervalued companies in the world, based on their calculation of a firm’s sustainable free cash flow discounted by conditions in the firm’s home country. They look, in particular, at free cash flow from operations minus the capital expenditures needed to maintain those operations. By using conservative assumptions about growth and a high discount rate, the system builds a wide margin of safety into its modeling.

The managers overlay those factors with an additional set of risk control in recognition of the fact that individual international small cap stocks are going to be volatile, no matter how compelling the underlying firm’s business model and practices.

Mr. Biswas remembers Mr. Horn’s warning, long ago, that emerging markets stocks are intrinsically volatile. Thinking that he’d found a way around the volatility trap, Biswas targeted a portfolio of defensive essentials, such as rice, fish and textbooks, and then discovered that even “essentials” might plummet 80% one year then rocket 90% the next.

Among the risk management tools they use are position sizing and an attempt to understand what really matters to the firm’s prospects. The normal position size is 1.6% of assets, but they might invest just half of that in a stock with limited liquidity. 

They are typically overweight companies in five sectors: utilities, telecom, healthcare, energy and materials.  The defensive sectors of utilities, telecom and healthcare are only 15% of the 17,000 companies in the small-cap universe. Energy is less than 5% of the same universe.   Materials is adequately represented in the 17,000 company set.  However, finding value opportunities (businesses with stable cash flows with limited down side risk at high discount rates) in these sectors is often challenging. In view of the above, they typically overweight companies in these 5 sectors to ensure greater diversification and lower portfolio volatility.

Because small companies are often monoline, that is they do or make just one thing, their prospects are easier to understand than are those of larger firms, at least once you understand what to pay attention to. Mr. Biswas says that, for many of these firms, you need to understand just three or four key drivers. The other factors, he says, have “low marginal utility.” If you can simplify the firm’s business model, identify the drivers and then learn how to talk with management about them, you can quickly verify a stock’s fundamental attractiveness.

Because those factors change slowly and the portfolio is compact with low turnover (about 10% per year so far, though that might rise over time to the 20-30% range), it’s entirely possible for a small team to track their investible universe.

Bottom Line

This is about the most consistent and most consistently risk-conscious international small cap fund around. It has, since inception, maintained its place among the best funds in its universe and has handily outperformed both the only Gold-rated international small value fund (DFA International Small Value DSIVX) and its average peer by a lot. It has done that while compiling the group’s most attractive risk-return profile. Any fund that invests in such risky assets comes with the potential for substantial losses. That includes this fund. The managers have done an uncommonly good job of anticipating those risks and executing a system that is structurally risk-averse. While they will not always lead the pack, they will – on average and over time – serve their investors well. They deserve a place near the top of the due diligence list for investors interested in risk assets that have not yet run their course.

Fund website

Pear Tree Polaris Foreign Value Small Cap. For those looking for a short introduction to the characteristics of international or global small caps as an asset class, you might consider Chris Tessin’s article “International Small Cap A Missed Opportunity” from Pensions & Investments (2013)

Fact Sheet

(2023)

Objective and strategy

The fund pursues long-term capital appreciation by investing in large cap growth stocks, which it defines generously as those with capitalizations over $5 billion. The manager describes his style as having a “value orientation toward growth.” Their discipline combines a macro-level sensitivity to the effects of powerful and enduring secular changes and on industries which are being disrupted, with intense fundamental research and considerable patience. The fund holds a fair fraction of its portfolio, about 20% at the end of 2014, in mid-cap stocks and has a small lower market cap, lower turnover and more compact portfolio than its peers. Most portfolio positions are weighted at about 2-3% of assets.

Adviser

RiverPark Advisors, LLC. RiverPark was formed in 2009 by former executives of Baron Asset Management. The firm is privately owned, with 84% of the company being owned by its employees. They advise, directly or through the selection of sub-advisers, the seven RiverPark funds. Overall assets under management at the RiverPark funds were over $3.5 billion as of September, 2014.

Manager

Mitch Rubin, a Managing Partner at RiverPark and their CIO. Mr. Rubin came to investing after graduating from Harvard Law and working in the mergers and acquisitions department of a law firm and then the research department of an investment bank. The global perspective taken by the M&A people led to a fascination with investing and, eventually, the opportunity to manage several strategies at Baron Capital. He’s assisted by RiverPark’s CEO, Morty Schaja, and Conrad van Tienhoven, a long-time associate of his. Mitch and his wife are cofounders of The IDEAL School of Manhattan, a small school where gifted kids and those with special needs study and play side-by-side.

Strategy capacity and closure

While Morty Schaja describes capacity and closure plans as “somewhat a comical issue” for a tiny fund, he estimates capacity “to be around $20 billion, subject to refinement if and when we get in the vicinity.” We’ll keep a good thought.

Active share

79.6, as of November 2014. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. As a rule of thumb, large cap funds with an active share over 70 have legitimately “active” managers while the median for Morningstar’s large cap Gold funds is 76. The active share for RiverPark Large Growth is 79.6, which reflects a high level of independence from its benchmark, the S&P 500 index.

Management’s stake in the fund

Mr. Rubin and Mr. Schaja each have over $1 million invested in the fund. Between them, they own 70% of the fund’s institutional shares. One of the fund’s three trustees has invested between $10,000 and $50,000 in the fund while the other two have not invested in it. As of December 31, 2013, the Trustees and officers of the Trust, as a group, owned 16.27% of the outstanding shares of the fund.

We’d also like to compliment RiverPark for exemplary disclosure: the SEC allows funds to use “over $100,000” as the highest report for trustee ownership. RiverPark instead reports three higher bands: $100,000-500,000, $500,000-1 million, over $1 million. That’s really much more informative than the norm.

Opening date

September 30, 2010.

Minimum investment

The minimum initial investment in the retail class is $1,000 and in the institutional class is $50,000.

Expense ratio

Retail class at 1.23% and institutional class at 0.95% on total assets of $38.3 million, as of July 2023.

Comments

If we had written this profile in January 2014 instead of January 2015, our text could have been short and uncontroversial.  It would read something like:

Mitch Rubin is one of the country’s most experienced growth managers. He’s famously able to follow companies for decades, placing them first in one of the small cap funds he’s run, later in a large cap fund before selling them when they plateau and shorting them as they enter their latter years. With considerable discipline and no emotional investment in any of his holdings, he has achieved outstanding results here and in his earlier charges. From inception through the end of 2013, Large Growth has dramatically outperformed both its large cap growth peer group and the S&P500, and had easily matched or beaten the performance of the top tier of growth funds.  That includes Sequoia (SEQUX), RiverPark Wedgewood (RWGFX), Vanguard PRIMECAP (VPMCX) and the other Primecap funds.

Accurate, true and sort of dull.

Fortunately, 2014 gave us a chance to better understand the fund and Mr. Rubin’s discipline. How so? Put bluntly, the fund’s short-term performance sort of reeked and it managed to reduce a five-star rating down to a three-star one. While it finished 2014 with a modest profit, the fund trailed more than 90% of its large-growth peers. That one year slide then pulled its three-year record from “top 10%” to “just above average.”

The question is: does 2014 represent “early” (as in, the fund moved toward great companies whose discount to fair value kept growing during the year) or “wrong” (that is, making an uninformed, undisciplined or impulsive shift that blew up)? If it’s the former, then 2014’s lag offers reasons to buy the fund while its portfolio is underpriced. If it’s the latter, then it’s time for investors to move on.

Here’s the case that Mitch, Conrad and Morty make for the former.

• They’re attempting to invest in companies which will grow by at least 20% a year in the future, in hopes of investing in stocks which will return 20% a year for the period we hold them. Since no company can achieve that rate of growth, the key is finding growth that is substantially underpriced.
• There’s a sort of time arbitrage at work, a claim that’s largely substantiated by a lot of behavioral finance research. Investors generally do not give companies credit for high rates of growth until that growth has been going on for years, at which point they pile in. RiverPark’s goal is to anticipate where next year’s growth is going to be, rather than buying where last year’s growth – or even this year’s growth – was.
• The proper questions then are (1) is the company’s performance outpacing its stock performance? And, if so, (2) can that performance be sustained? If you answer “yes” to both, then it’s probably time to buy. The mantra was “buy, hold, and, if necessary, double down.”
• If they’re right, in 2014 they bought a bunch of severely underpriced growth. The firms in the portfolio are growing earnings by about 20% a year and they’re paying a 16x p/e for those stocks. Investors in the large cap universe in general are also paying a 16x p/e, but they’re doing it for stocks that are growing by no more than 7% annually.

Those lower quality firms have risen rapidly, bolstered by low interest rates which have made it cheap for them to buy their way to visibility through financial engineering; debt refinance, for example, might give a one-time boost to shaky earnings while cheap borrowing encourages them to “buy growth” by acquiring smaller firms. Such financial engineering, though, doesn’t provide a basis for long-term growth. For the Large Growth portfolio, they target firms with “fortress-like balance sheets.”

So, they buy great growth companies for cheap. How does that explain the sudden sag in 2014? They point to three factors:

• Persistently low interest rates: in the short term, they prop up the fortunes of shaking companies, whose stock prices continue to rise as late-arriving investors pile in. In the interim, those rates punish cash-rich financial services firms like Schwab (SCH) and Blackstone Group (BX)
• Energy repricing: about 13% of the portfolio is focused on energy firms, about twice the category average. Three of their four energy stocks have lost money this year, but are cash-rich with a strong presence in the Marcellus shale region. Globally natural gas sells for 3-4 times more than it does in the US; our prices are suppressed by a lack of transport capacity. As that becomes available, our prices are likely to move toward the global average – and the global average is likely to rise as growth resumes.
• Anti-corruption contagion: the fund has a lot of exposure to gaming stocks and gaming companies have a lot of exposure to Asian gambling and retail hubs such as Macau. Those are apt to be incredibly profitable long-term investments. The Chinese government has committed to $500 billion in new infrastructure investments to help middle class Chinese reach Macau, and Chinese culture puts great stock in one’s willingness to challenge luck. As a result, Chinese gamblers place far higher wagers than do Western ones, casinos catering to Chinese gamblers have far higher margins (around 50%) than do others and the high-end retailers placed around those casinos rake in about $7,000 per square foot, well more than twice what high-end stores here make. In the short term, though, Prime Minister Xi’s anti-corruption campaign has terrified Chinese high-rollers who are buying and gambling a lot less in hopes of avoiding the attention of crusaders at home. While the long-term profits are driven by the mass market, in the short-term their fate is tied to the cowed high-wealth cohort.

Sooner rather than later, the managers argue, energy prices will rise and firms like Cabot Oil & Gas (COG) will see their stocks soar. Sooner rather than later, the gates of Macau will be opened to hundreds of millions of Chinese vacationers, anxious to challenge luck and buy some bling and stocks like Wynn Resorts (WYNN) will rise dramatically.

This is not a high turnover, momentum strategy designed to capture every market move. Almost all of the apparent portfolio turnover is simply rebalancing within the existing names in order to capture a better risk/return profile. It’s a fairly patient strategy that has, for decades, been willing to tolerate short-term underperformance as the price of long-term outperformance.

Bottom Line

The argument for RiverPark is “that spring is getting compressed tighter and tighter.” That is, a manager with a good track record for identifying great underpriced growth companies and then waiting patiently currently believes he has a bunch of very high quality, very undervalued names in the portfolio. They point to the fact that, for 26 of the 39 firms in the portfolio, the firm’s underlying fundamentals exceeded the market while the stock price in 2014 trailed it. It is clear that the manager is patient enough to endure a flat year or two as the price for long-term success; the fund has, after all, returned an average of 20% a year. The question is, are you?

Fund website

RiverPark Large Growth. Folks interested in hearing directly from Messrs. Rubin and Schaja might listen to our December 2014 conference call with them, which is housed on the Featured Fund page for RiverPark Large Growth.

Fact Sheet

Objective and strategy

Polaris Global Value attempts to provide above average return by investing in companies with potentially strong sustainable free cash flow or undervalued assets. Their goal is “to invest in the most undervalued companies in the world.” They combine quantitative screens with Graham and Dodd-like fundamental research. The fund is diversified across country, industry and market capitalization. They typically hold 50 to 100 stocks.

Adviser

Polaris Capital Management, LLC. Founded in 1995, Polaris describes itself as a “global value equity manager.” The firm is owned by its employees and, as of September 2014, managed $5 billion for institutions, retirement plans, insurance companies, foundations, endowments, high-net-worth individuals, investment companies, corporations, pension and profit sharing plans, pooled investment vehicles, charitable organizations, state or municipal governments, and limited partnerships. They subadvise four funds include the value portion of the PNC International Equity, a portion of the Russell Global Equity Fund and two Pear Tree Polaris funds.

Manager

Bernard Horn. Mr. Horn is Polaris’s founder, president and senior portfolio manager. Mr. Horn founded Polaris in April 1995 to expand his existing client base dating to the early 1980s. Mr. Horn has been managing Polaris’ global and international portfolios since the firm’s inception and global equity portfolios since 1980. He’s both widely published and widely quoted. He earned a BS from Northeastern University and a MS in Management from MIT. In 2007, MarketWatch named him their Fund Manager of the Year. Mr. Horn is assisted by six investment professionals. They report producing 90% of their research in-house.

Strategy capacity and closure

Substantial. Mr. Horn estimates that they could manage $10 billion firm wide; current assets are at $5 billion across all portfolios and funds.. That decision has already cost him one large client who wanted Mr. Horn to increase capacity by managing larger cap portfolios.

About half of the global value fund’s current portfolio is in small- to mid-cap stocks and, he reports, “it’s a pretty small- to mid-cap world. Something like 80% of the world’s 39,000 publicly traded companies have market caps under $2 billion.” If this strategy reaches its full capacity, they’ll close it though they might subsequently launch a complementary strategy.

Active share

Polaris hasn’t calculated it. It’s apt to be high since, they report “only 51% of the stocks in PGVFX overlap with the benchmark” and the fund’s portfolio is equal-weighted while the index is cap-weighted.

Management’s stake in the fund

Mr. Horn has over $1 million in the fund and owns over 75% of the advisor. Mr. Horn reports that “All my money is invested in the funds that we run. I have no interest in losing my competitive advantage in alpha generation.” In addition, all of the employees of Polaris Capital are invested in the fund.

Opening date

July 31, 1989.

Minimum investment

$2,500, reduced to $2,000 for IRAs. That’s rather modest in comparison to the $75 million minimum for their separate accounts.

Expense ratio

0.99% on $399 million in assets, as of July 2023. The expense ratio was reduced at the end of 2013, in part to accommodate the needs of institutional investors. With the change, PGVFX has an expense ratio in the bottom third of its peer group.

Comments

There’s a lot to like about Polaris Global Value. I’ll list four particulars:

1. Polaris has had a great century. $10,000 invested in the fund on January 1, 2000 would have grown to $36,600 by the end of November 2014. Its average global stock peer was pathetic by comparison, growing $10,000 to just $16,700. Focus for a minute on the amount added to that initial investment: Polaris added $26,600 to your wealth while the average fund would have added $6,700. That’s a 4:1 difference.
2. It’s doggedly independent. Its median market cap – $8 billion – is about one-fifth of its peers’. The stocks in its portfolio are all about equally weighted while its peers are much closer to being cap weighted. It has substantially less in Asia and the US (50%) than its peers (70%), offset by a far higher weighting in Europe. Likewise its sector weightings are comparable to its peers in only two of 11 sectors. All of that translates to returns unrelated to its peers: in 1998 it lost 9% while its peers made 24% but it made money in both 2001 and 2002 while its peers lost a third of their money.
3. It’s driven by alpha, not assets. The marketing for Polaris is modest, the fund is small, and the managers have been content having most of their assets reside in their various sub-advised funds.
4. It’s tax efficient. Through careful management, the fund hasn’t had a capital gains payout in years; nothing since 2008 at least and Mr. Horn reports a continuing tax loss carry forward to offset still more gains.

The one fly in the ointment was the fund’s performance in the 2007-09 market meltdown. To be blunt, it was horrendous. Between October 2007 and March 2009, Polaris transformed a $10,000 account into a $3,600 account which explains the fund’s excellent tax efficiency in recent years. The drop was so severe that it wiped out all of the gains made in the preceding seven years.

Here’s the visual representation of the fund’s progress since inception.

Okay, if that one six quarter period didn’t exist, Polaris would be about the world’s finest fund and Mr. Horn wouldn’t have any explaining to do.

Sadly, that tumble off a cliff does exist and we called Mr. Horn to talk about what happened then and what he’s done about it. Here’s the short version:

“2008 was a bit of an unusual year. The strangest thing is that we had the same kinds of companies we had in the dot.com bubble and were similarly overweight in industrials, materials and banks. The Lehman bankruptcy scared everyone out of the market, you’ll recall that even money market funds froze up, and the panic hit worst in financials and industrials with their high capital demands.”

Like Dodge & Cox, Polaris was buying when prices were at their low point in a generation, only to watch them fall to a three generation low. Their research screens “exploded with values – over a couple thousand stocks passed our initial screens.” Their faith was rewarded with 62% gains over the following two years.

The experience led Mr. Horn and his team to increase the rigor of their screening. They had, for example, been modeling what would happen to a stock if a firm’s growth flat lined. “Our screens are pretty pessimistic; they’re designed to offer very, very conservative financial models of these companies” but 2008 sort of blindsided them. Now they’re modeling ten and twenty percent declines as a sort of stress test. They found about five portfolio companies that failed those tests and which they “kinda got rid of, though they bounced back quite nicely afterward.” In addition they’ve taken the unconventional step of hiring private investigators (“a bunch of former FBI guys”) to help with their due diligence on corporate management, especially when it comes to non-U.S. firms.

He believes that the “soul-searching after 2008” and a bunch of changes in their qualitative approach, in particular greater vigilance for the sorts of low visibility risks occasioned by highly-interconnected markets, has allowed them to fundamentally strengthen their risk management.

As he looks ahead, two factors are shaping his thinking about the portfolio: deflation and China.

On deflation: “We think the developed world is truly in a period of deflation. One thing we learned in investing in Japan for the past 5 plus years, we were able to find companies that were able to raise their operating revenue and free cash flows during what most central bankers would consider the scourge of the economic Earth.” He expects very few industries to be able to raise prices in real terms, so the team is focusing on identifying deflation beating companies. The shared characteristic of those firms is that they’re able to – or they help make it possible for other firms – to lower operating costs by more than the amount revenues will fall. “If you can offer a company product that saves them money – only salvation is lowering cost more dramatically than top line is sinking – you will sell lots.”

On China: “There’s a potential problem in China; we saw lots of half completed buildings with no activity at all, no supplies being delivered, no workers – and we had to ask, why? There are many very, very smart people who are aware of the situation but claim that we’re more worried than we need to be. On whole, Chinese firms seem more sanguine. But no one offers good answers to our concerns.” Mr. Horn thinks that China, along with the U.S. and Japan, are the world’s most attractive markets right now. Still he sees them as a potential source of a black swan event, perhaps arising from the unintended consequences of corruption crackdowns, the government ownership of the entire banking sector or their record gold purchases as they move to make their currency fully convertible on the world market. He’s actively looking for ways to guard against potential surprises from that direction.

Bottom Line

There’s a Latin phrase often misascribed to the 87-year-old titan, Michelangelo: Ancora imparo. It’s reputedly the humble admission by one of history’s greatest intellects that “I am still learning.” After an hour-long conversation with Mr. Horn, that very phrase came to mind. He has a remarkably probing, restless, wide-ranging intellect. He’s thinking about important challenges and articulating awfully sensible responses. The mess in 2008 left him neither dismissive nor defensive. He described and diagnosed the problem in clear, sharp terms and took responsibility (“shame on us”) for not getting ahead of it. He seems to have vigorously pursued strategies that make his portfolio better positioned. It was a conversation that inspired our confidence and it’s a fund that warrants your attention.

Fund website

Polaris Global Value

Fact Sheet

FPA Paramount Fund was reorganized as Phaeacian Global Value Fund.

Objective and Strategy

The FPA Global Value Strategy will seek to provide above-average capital appreciation over the long term while attempting to minimize the risk of capital losses by investing in well-run, financially robust, high-quality businesses around the world, in both developed and emerging markets. The portfolio holds between 25-50 stocks, 33 at present. As of October 2014, the fund’s cash stake was 16.7%.

Adviser

FPA, formerly First Pacific Advisors, which is located in Los Angeles. The firm is entirely owned by its management which, in a singularly cool move, bought FPA from its parent company in 2006 and became independent for the first time in its 50 year history. The firm has 28 investment professionals and 72 employees in total. Currently, FPA manages about $33 billion across five equity strategies and one fixed income strategy. Each strategy is manifested in a mutual fund and in separately managed accounts; for example, the Contrarian Value strategy is manifested in FPA Crescent (FPACX), in nine separate accounts and a half dozen hedge funds. On April 1, 2013, all FPA funds became no-loads.

Managers

Pierre O. Py and Greg Herr. Mr. Py joined FPA in September 2011. Prior to that, he was an International Research Analyst for Harris Associates, adviser to the Oakmark funds, from 2004 to 2010. Mr. Py has managed FPA International Value (FPIVX) since launch. Mr. Herr joined the firm in 2007, after stints at Vontobel Asset Management, Sanford Bernstein and Bankers Trust. He received a BA in Art History at Colgate University. Mr. Herr co-manages FPA Perennial (FPPFX) and the closed-end Source Capital (SOR) funds with the team that used to co-manage FPA Paramount. Py and Herr will be supported by the two research analysts, Jason Dempsey and Victor Liu, who also contribute to FPIVX.

Strategy capacity and closure

Undetermined.

Active share

99.6. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. The active share for Paramount is 99.6 measured against an MSCI all-world index, which reflects extreme independence.

Management’s Stake in the Fund

At December 31, 2013, by Mr. Herr was between $100,001 and $250,000, and by Mr. Py was still $0 after two years as manager. Mr. Py did have a very large investment in his other charge, FPA International Value. Three of the five independent trustees had between $10,000 and $50,000 invested in the fund, a fourth trustee had over $100,000 and the final trustee was relatively new to the organization and had no investment in the fund.

Opening date

September 8, 1958.

Minimum investment

$1,500, reduced to $100 for IRAs or accounts with automatic investing plans.

Expense ratio

1.26% on $304 million in assets, as of October, 2014. That is 32 basis points higher than it was a year earlier. Mr. Herr explained that the fund’s board of trustees and shareholders approved a higher management fee; global funds typically charge more than domestic ones in recognition of the fact that such portfolios are costlier to assemble and maintain. The fund remains less expensive than its peers.

Comments

Until September 2013, FPA Paramount and FPA Perennial (FPPFX) were essentially clones of one another. High quality clones, but clones nonetheless. FPA has decided to change that. Beginning in 2011, they began to transition-in a new management team by adding Messrs Herr and Py to the long-tenured team of Stephen Geist and Eric Ende. In September 2013, Messrs Geist and Ende focused all of their efforts on Perennial while Herr and Py have sole charge of Paramount.

That same month, the fund shifted its principal investment strategies to more closely mirror the approach taken in FPA International Value (FPIVX). Ende and Geist stayed fully invested in high-quality domestic small and mid-cap stocks. Herr and Py pursued a global, absolute value strategy. That shift shows up in three ways:

1. The market cap has climbed. Paramount’s market cap is about four times higher than it was a year ago.
2. The global exposure has climbed. They’ve shifted from about 10% non-US to about 50%.
3. The cash stash has climbed. Ende and Geist generally held frictional cash, 3-4% or so. Herr and Py have nearly 17%. At base, an absolute value discipline holds that you should not put money into risky assets unless you’re being more than compensated for those risks. If valuations are high, future returns are iffy and the party’s roaring on, absolute value investors hold cash and wait.

Sadly, the performance has not climbed. Between the date of the strategy transition and October 30, 2014, a $10,000 investment in Paramount would have grown to $10,035. The average global stock fund would have provided $11,670. The fund had been modestly trailing its peers until the 3^rd quarter of 2014, when it dropped 9% compared to a modest 3.3% loss for its peers.

Manager Greg Herr and I talked about the fund’s performance in late October, 2014. He attributed the fund’s modest lag through the beginning of July to three factors:

1. A small drag from unhedged foreign currency exposure, primarily the euro and pound.
2. A more substantial drag from the fund’s largest cash stake.
3. The inevitable lag of a value-oriented portfolio in a growth-oriented period.

The more substantial lag from July to the present seems largely driven by the fund’s hidden emerging markets exposure, and particularly exposure to the EM consumer. The fund added five new positions in the second quarter of 2014 (Adidas, ALS Limited, Hypermarcas SA, Prada TNT Express) which have significant EM exposure. Adidas, for example, is the world’s largest provider of golf equipment and supplies; it has consciously expanded into the emerging markets, including adding 850 outlets in Russia. Oops. Prada is the brand of choice for Chinese consumers looking to express their appreciation to local elected officials, a category that’s been dampened by an anti-corruption initiative. Hypermarcas is a Brazilian retailer selling global brands (Johnson & Johnson products, for example) into a market destabilized by economic and political uncertainty ahead of recent presidential elections.

The largest hit came from their stake in Fugro, a Dutch oil services company that does a lot of the geoscience stuff for exploration and production companies. The stock dropped 40% in July on profit warnings, driven by a combination of a deterioration in the oil & gas exploration business and in some “company-specific issues.” David Herro, who managers Oakmark International and who also owns a lot of Fugro, remains “a firm shareholder” because he thinks Fugro has great potential.

Herr and Py agree. They continue to monitor their holdings, but believe that the portfolio is now deeply undervalued which means it’s also positioned to produce abnormally high returns. They’ve continued adding to some of these positions as the value deepened. In addition, the market instability in the third quarter is beginning to drive the price of some strong businesses – perhaps five or six are “near the door” – low enough to provide potential near-term uses for the fund’s large cash reserve.

Bottom Line

It’s hard being independent and this is a very independent fund. When a member of the investment herd is out-of-step with the rest of the herd, it’s likely to be only marginally and almost invisible so. It remains safely masked by mediocrity. When a highly independent fund is out-of-step, it’s really visible and can cause considerable shareholder anxiety. That said, the question is whether you’re better served by understanding and reacting to the distinctive tactics of an absolute value portfolio or by reacting to a single striking quarter. The latter is certainly the common response, which almost surely means it’s the wrong one. That said, FPA’s recent and substantial fee increase has raised the bar for Paramount’s managers and have disadvantaged its shareholders. The fund is intriguing but the business decision is regrettable.

Fund website

FPA Paramount Fund

At the time of publication, this fund was named Matthews Asia Strategic Income.

We’ve published several profiles of MAINX.  for background, our February 2013 profile is here.

*Matthews Asia liquidated their two fixed-income funds in March, 2023. In consequence, the information for Marathon Value should be read for archival purposes only.*

Objective and Strategy

MAINX seeks total return over the long term with an emphasis on income. The fund invests in income-producing securities including, but not limited to, debt and debt-related instruments issued by 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 and advises the 15 Matthews Asia funds. As of July 31, 2014, Matthews had $27.3 billion in assets under management. On whole, the Matthews Asia funds offer below average expenses. 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 and Satya Patel. Mr. Hwang for three years managed foreign exchange and fixed income assets for some of Vanguard’s exchange-traded funds and mutual funds before joining Matthews in 2011. Mr. Patel worked more in the hedge fund and private investments universe.

Strategy capacity and closure

“We are,” Ms. Kong notes, “a long way from needing to worry about that.” She notes that Matthews has a long record of moving to close their funds when asset flows and market conditions begin to concern the manager. Both the $8 billion Pacific Tiger (MAPTX) and $5.4 billion Asia Dividend (MAPIX) funds are currently closed.

Management’s Stake in the Fund

As of the April 2014 Statement of Additional Information, Ms. Kong had between $100,000 and 500,000 invested in the fund, as well as substantial investments in seven other Matthews funds.  There’s no investment listed for her co-managers. In addition, two of the fund’s five trustees have invested in it: Geoffrey Bobroff has between $10,000 – 50,000 and Mr. Matthews has over $100,000.

Opening date

November 30, 2011.

Minimum investment

$2500 for regular accounts, $500 for IRAs for the retail shares. The fund’s available, NTF, through most major supermarkets.

Expense ratio

1.10%, after waivers, on $66 million in assets (as of August, 2014). There’s also a 2% redemption fee for shares held fewer than 90 days. The Institutional share class (MINCX) charges 0.90% and has a $3 million minimum.

Comments

If I spoke French, I’d probably shrug eloquently, gesture broadly with an impish Beaujolais and declare “plus ça change, plus c’est la même chose.” (Credit Jean-Baptiste Alphonse Karr, 1849.)

After four conversations with Teresa Kong, spread out over three years, it’s clear that three fundamental things remain unchanged:

1. Asia remains a powerful and underutilized source of income for many investors. The fundamentals of their fixed-income market are stronger than those in Europe or the U.S. and most investors are systematically underexposed to the Asian market. That underexposure is driven by a quirk of the indexes and of all of the advisors who benchmark against them. Fixed income indexes are generally debt-weighted, that is, they give the greatest weight to the most heavily indebted issuers. Since few of those issuers are domiciled in Asia, most investors have very light exposure to a very dynamic region.
2. Matthews remains the firm best positioned to help manage your exposure there. The firm has the broadest array of funds, longest history and deepest analyst core dedicated to Asia of any firm in the industry.
3. MAINX remains a splendid tool for gaining that exposure. MAINX has the ability to invest across a wide array of income-producing securities, including corporate (61% of the portfolio, as of August 2014) and government (22%) bonds, convertibles (9%), equities (5%) and other assets. It has the freedom to hedge its currency exposure and to change duration in response to interest rate shifts. The fund’s risk and return profile maximum drawdown continues to track the firm’s expectations which is good given the number of developments which they couldn’t have plausibly predicted before launch. Ms. Kong reports that “the maximum drawdown over one- and three- months was -4.41% and -5.84%, which occurred in June and May-July 2013, respectively. This occurred during the taper tantrum and is fully in-line with our back-tests. From inception to July 2014, the strategy has produced an annualized return of 6.63% and a Sharpe ratio of 1.12 since inception, fully consistent with our long-term return and volatility expectations.”

The fund lacks a really meaningful Morningstar peer group and has few competitors. That said, it has substantially outperformed its World Bond peer group (the orange line), Aberdeen Asian Bond (AEEAX, yellow) and Wisdom Tree Asia Local Debt ETF (ALD, green).

In our August 2014 conversation, Ms. Kong made three other points which are relevant for folks considering their options.

1. the US is being irreversibly marginalized in global financial markets which is what you should be paying attention to. She’s neither bemoaning nor celebrating this observation, she’s just making it. At base, a number of conditions led to the US dollar becoming the world’s hegemonic currency which was reinforced by the Saudi’s decision in the early 1970s to price oil only in US dollars and to US investment flows driving global liquidity. Those conditions are changing but the changes don’t seem to warrant the attention of editors and headline writers because they are so slow and constant. Among the changes is the rise of the renminbi, now the world’s #2 currency ahead of the euro, as a transaction currency, the creation of alternative structures to the IMF which are not dollar-linked or US driven and a frustration with the US regulatory system (highlighted by the $9B fine against BNP Paribas) that’s leading international investors to create bilateral agreements that allow them to entirely skirt us. The end result is that the dollar is likely to be a major currency and perhaps even the dominant currency, but investors will increasingly have the option of working outside of the US-dominated system.
2. the rising number of “non-rated” bonds is not a reflection on credit quality: the simple fact is that Asian corporations don’t need American money to have their bond offerings fully covered and they certainly don’t need to expense and hassle of US registration, regulation and paying for (compromised) US bond rating firms to rate them. In lieu of US bond ratings, there are Asia bond-rating firms (whose work is not reflecting in Morningstar credit reports) and Matthews does extensive internal research. The depth of the equity-side analyst corps is such that they’re able “to tear apart corporate financials” in a way that few US investors can match.
3. India is fundamentally more attractive than China, at least for a fixed-income investor. Most investors enthused about India focus on its new prime minister’s reform agenda. Ms. Kong argues that, by far, the more significant player is the head of India’s central bank, who has been in office for about a year. The governor is intent on reducing inflation and is much more willing to deploy the central bank’s assets to help stabilize markets. Right now corporate bonds in India yield about 10% – not “high yield” bond but bonds from blue chip firms – which reflects a huge risk premium. If inflation expectations change downward and inflation falls rather than rises, there’s a substantial interest rate gain to be harvested there. The Chinese currency, meanwhile, is apt to undergo a period of heightened volatility as it moves toward a free float; that is, an exchange rate set by markets rather than by Communist Party dictate. She believes that that volatility is not yet priced in to renminbi-denominated transactions. Her faith is such that the fund has its second greatest currency exposure to the rupee, behind only the dollar.

Bottom Line

MAINX offers rare and sensible access to an important, under-followed asset class. The long track record of Matthews Asia funds suggests that this is going to be a solid, risk-conscious and rewarding vehicle for gaining access to that class. The fund remains small though that will change. It will post a three-year record in November 2014 and earn a Morningstar rating by year’s end; the chart above hints at the possibility of a four- or five-star rating. Ms. Kong also believes that it’s going to take time for advisors get “more comfortable with Asia Fixed Income as an asset class. It took a decade or so for emerging markets to become more widely adopted and we expect that Asia fixed income will become more ubiquitous as investors gain comfort with Asia as a distinct asset class.” You might want to consider arriving ahead of the crowd. 

Disclosure: while the Observer has no financial or other ties to Matthews Asia or its funds, I do own shares of MAINX in my personal account and have recently added to them.

Fund website

Matthews Asia Strategic Income homepage and Factsheet. There’s a link to a very clear discussion of the fund’s genesis and strategy in a linked document, entitled Matthews Q&A.  It’s worth your time.