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How a top China small cap fund reduces risk

A ‘healthy dose of paranoia’ has helped Tiffany Hsiao keep her fund top of the heap over multi-year periods.

California-based Hsiao, who has been lead manager of the Matthews China Small Companies Fund since 2015, has seen her portfolio hold up remarkably well in the year of the coronavirus pandemic.

The fund is up 24% and well ahead of its benchmark and category average (chart below).

Its 2.02 Sharpe ratio was the highest of the 107 products in the SFC-registered China equity fund category, though volatility was outsized at 33.49 vs the category average of 25.96.

Over a five-year period, the fund makes a more compelling argument – up 70% while the benchmark and category average were double-digit negative (second chart below).

China risk management

In a recent Matthews Asia podcast, Hsiao shed some light on how she is managing risk.

As the coronavirus pandemic recedes, tensions between the US and China are likely to become even more strained. Hsiao said she has identified small caps that are likely to benefit from rising geopolitical tensions.

“These are companies helping China to become more self-sufficient, helping to source critical parts of new economy infrastructure,” she said.

Semiconductor, software and biotech small caps are three examples.

She emphasized that China needs to build its semiconductor industry in order to grow the new economy which includes internet businesses and tech innovations such as smart cars, robotics and 5G gear.

Her portfolio’s top holding – Silergy – is a mixed-signal and analog chip design firm.

“China is the world’s largest importer of oil – but China’s largest import by value its semiconductors. It imports 80% of is semiconductor needs. Innovative and consumption-driven companies are driving the economy and without semiconductors there will not be a stable internet to grow these companies, so they need more of a domestic source.

Even if geopolitical backlash against China rises, “it will continue to grow its semiconductor ecosystem and the small players will benefit tremendously.”

Fraud factors

Small caps are under-invested and compared to China’s internet giants, are unknown. The top ten holdings in Hsiao’s fund are far from household names:

Source: FE Fundinfo as of 31 March 2020

Because of the lack of information and robust growth of China’s small caps, she said they are particularly vulnerable to fraud. Information the companies present publicly may be inaccurate or simply not true.

Moreover, data such as sales figures can be more easily manipulated in companies with an internet business model, something which is suspected in the case of Luckin Coffee.

“You need a healthy dose of paranoia,” she explained.

“We do private equity-like due diligence, meaning we assume public information should be taken with a grain of salt. Everything has to be verified.

“We spend a lot of time on the G in ESG, doing background checks to understand if [management] qualifications are accurate or not, going back to the prior jobs of the founders and finding people who worked with them.

“Can we trust [the founder]? What are their strengths and weaknesses? That gives us color to judge whether they are cutting corners or cheating investors.”

With internet business models, she said they crosscheck company-provided data by subscribing to alternate data sets to see which products are selling on the internet. Another example is getting access to a company’s chief technology officer to ensure the technology investment will support the expected strong growth.

Due diligence on a company usually takes two years, she said.

“When all these factors combine, then that gives us a positive signal and we begin to have confidence in the company.”


Year-to-date performance vs category and benchmark

Source: FE Fundinfo. Year to 28 April, in US dollars.



Five year performance vs category and benchmark

Source: FE Fundinfo. In US dollars, five years to 28 April 2020.

Part of the Mark Allen Group.