Picking The Right Horse For A Small Cap Fund

For the longest time, I’ve worried about the performance of LM SEA Special Sits in my portfolio. Finally, I’ve found the time to compare the alternative I’ve been mulling around my head as a replacement for the fund – Aberdeen Asian Smaller Cos.

As at 30 Sep, here’s what my portfolio looks like:

Despite making a bit of money in the recent upsurge (thanks QE3!), I’m still facing a loss on my China exposure, and my US exposure, which proxies for developed equity exposure, because…well…I couldn’t find a compelling global equity fund (although DWS Top Div might be an interesting proposition).

In any case, this article tracks my thoughts on whether I should change my exposure to Legg Mason QA SEA Special Sits to Aberdeen Asian Small Cos. I find writing this down gives me a point of reference for the future, so I can have a clearer idea of what in the world I was thinking when I made the decision, or to leave a digital trail to prove my sometimes questionable frontal lobe activity.

In any case I wrote about these two funds approximately a year ago, when I compared both of them against one Mr Madoff, who had delivered 10% annualized returns consistently until the day his Ponzi scheme collapsed. The funds since then have posted far more modest rates of return because the start and end-points have changed. And the Madoffs, post Ponzi collapse, have also faced a drastic change in lifestyle.

For sake of comparison, I’ve used the MSCI Asia Pacific ex-Japan index (MXAPJ:IND) as a common benchmark. The two official benchmarks are MSCI Far East (MXFE), and MSCI APJ Small Caps (MXAPJSC), which are close enough for the MSCI Asia Pacific ex-Japan index to provide a fair proxy.

Granted, neither fund uses this benchmark, but the other two benchmarks used track fairly closely, so I think it’s a reasonably (but certainly not perfect) useful benchmark.

In any case, enough yap flapping. This is how the two funds stack up:

From the above, it’s quite clear both sit on opposite sides of the spectrum – Legg Mason will do badly in down markets (like 2011) and will do well in up markets, often stunningly so, with an average outperformance of 40pp in strong bull markets. Meanwhile, Aberdeen, true to its reputation for being conservative stock pickers, does well in bear markets, but underperforms in bull markets.

So should I switch? If I do, it’ll be because I believe there’s more pain to come, and that Asian equity markets will get hammered, and from a valuations standpoint, it’s kind of middle of the road, so there’s little guidance there. In other words, markets seem rather wishy washy, and to quote the reformed broker, “Tops are a process, Bottoms are an event and Middles are a motherfucker.”