How Two Funds Beat the "Con of the Century"

Key Points:
- We searched for funds that can beat a 10% annualised return – the rate of return promised by Bernie Madoff
- Aberdeen Asian Smaller Cos and Legg Mason WA SEA Special Sits have both beaten the 10% annualised return
- Aberdeen Asian Smaller Cos by outperforming during down markets and Legg Mason WA SEA Special Sits outperforms during up markets

In their titular article, The Economist called Bernie Madoff the “Con of the Century” when in 2008, the US$17.1 billion of Madoff’s assets under management turned out to be more fiction than fact.

To get a clearer idea of the scam, I read Harry Markopolos’ 21-page report, “The World’s Largest Hedge Fund is A Fraud” which details the returns of Bernie Madoff’s hedge fund from 1990 to 2005.

I won’t bore you with the calculations. Suffice to say, over the 16 years, Madoff’s fund returned an annualised 11%, and did so with no negative years. Clearly, it was a lot of smoke and mirrors built on a foundation of wishful thinking – even Warren Buffett has negative years – but it’s an intriguing question to answer:

Are unit trusts capable of similar returns?

By ‘similar’ I mean 10% annualised returns or more. And to be clear, I fully expect the fund to have negative years – these are legitimate investors we’re talking about, tightly regulated and regularly audited. So on this merry note, we dive into the data.

Setting Boundaries
First off, we’ll limit our examination to the Asia small cap sector, because this is one sector where one would reasonably expect double-digit returns. We’ll look at funds with around 5 years of data, and examine its yearly and annualised performance.

For the benchmark, we went with MSCI Asia Pacific ex-Japan Index, which broadly captures the geographies covered by all the funds, as the funds we looked at invest in various geographies within the Asia Pacific ex-Japan space. Also, the small cap version of the MSCI Asia Pacific ex-Japan Index was only incepted sometime in 2H2007, hence for the sake of data, we went with the broad equity index.

Yearly Returns

Looking at yearly returns, we can make a few general observations about these funds.

One, they have the potential to post very strong returns. In 2009, United Asian Growth Opprt and Legg Mason WA SEA Special Sits returned in excess of 100%, while other funds such as APS Alpha Fund and HGIF Asia Ex-Jap Eq Sm Cos SGD AD returned more than 90%.

Two, these funds have the potential to post very negative returns. As with all investments, these funds can and will post negative years, sometimes to startling levels. Case in point being 2008; when the benchmark posted a -51.47% returns, only two funds beat the benchmark - Aberdeen Asian Smaller Cos and APS Alpha Fund benchmark – while the rest posted negative returns in excess of -50%.

One additional point: Legg Mason WA SEA Special Sits and APS Alpha Fund are not categorised as small cap funds in our Fund Selector. Strictly speaking, their investment mandate does not limit their exposure to just small-to-medium cap companies and hence they are categorised ‘General’ in sector. I’ve included these two funds on the basis of their portfolio holdings, which tend to be mostly in small and mid cap companies.

5-year Annualised Returns
Annualised returns smoothen out the market fluctuations and provide an indication of the returns investors would have experienced, had they held for a number of years.

For this article, we look at the 5-year annualised returns to see how the funds stand against the benchmark.

Table 2.1 illustrates the annualised performance that pushes Legg Mason WA SEA Special Sits to the top of the table. If we use 10% annualised returns as an arbitrary benchmark, this fund definitely beats it by a convincing margin. One other fund that marginally missed 10% annualised returns is HGIF Asia Ex-Jap Eq Sm Cos SGD AD, with 9.27% annualised return.
Two other funds have a slightly shorter track record, with 4 years of data, and here’s how they performed on a 4-year annualised basis.

Inching out of the 10% annualised return mark is Aberdeen Asian Smaller Cos with 10.59% annualised return over 4-years. Despite the relatively muted returns on a yearly basis, the fund does manage to outperform (and quite convincingly so) over longer periods.

Beating a Ponzi scheme is no mean feat for a legitimate investment, but at least two funds have shown performances that rival the annualised 10% return, albeit with the market fluctuations of a legitimate investment. The next section discusses how the funds did it.

Performance Across Market Conditions
On a quarterly basis, we divided our benchmark (the MSCI Asia Pacific ex-Japan Index) return into ‘up’, ‘sideways’ and ‘down’ on the following criteria: A quarterly return exceeding 2.5% is an ‘Up’ market; a quarterly return less than -2.5% is a ‘Down’ market; and a quarterly return between 2.5% and -2.5% is a ‘Sideways’ market.

We then looked at the performance of the fund across ‘Up’, ‘Down’ and ‘Sideways’ markets, and divided it into outperformance (fund return greater than benchmark return) and underperformance (fund return less than benchmark return).

Having stated our approach, we’ll begin with Aberdeen Asian Smaller Cos.

Chart 1 displays the performance of Aberdeen Asian Smaller Cos against the benchmark. Based on the chart and the yearly returns, the fund tends to do well in down market, but less so in up markets. But to get a more detailed picture, I’ve presented the numbers in Table 3.1, which shows the fund’s performance in various market conditions. (Note: Percentage points (pp) are a measure of the arithmetic difference between two percentages.)

We can see in an up market, the quarterly performance of the fund tends to underperform more than 60% of the time (5 of 8 quarters), and on average, the fund underperforms by -2.39pp. In sideways markets, the fund tends to underperform (or outperform) 50% of the time (2 of 4 quarters) and the fund outperforms sufficiently that on average, it still manages a 2.06pp outperformance during sideways markets. Where the fund truly shines is during down markets, where the fund outperforms in every quarter we examined (6 of 6 quarters), and averages 5.47pp outperformance.

This is how Aberdeen Asian Smaller Cos outperforms – by beating the market on the downside while averaging out a positive outperformance during sideways markets.

Let’s move on to the next fund: Legg Mason WA SEA Special Sits.

By eyeballing the chart, it seems the fund tends to do poorly in down markets (2Q2006 and 3Q2007) while it does well in up markets (1Q2007 and 2Q2009). Again for a clearer look, we drill down into the actual number to see how the fund reacts across market conditions.

We can see in an up market, the quarterly performance of the fund tends to outperform more than 60% of the time (7 of 11 quarters), and on average by a convincing 5.15pp. In the sideways quarters we examined, the fund underperforms 60% of the time (3 of 5 quarters) but manages to outperform on average by 2.71pp. This means the fund, while underperforming more often, outperforms by a sufficiently large margin such that the average performance during sideways markets is positive.

During down markets, the fund underperforms more than 60% of the time (4 of 6 quarters), and the average underperformance is -1.66pp. Comparing the underperformance during down markets with the outperformance during up markets suggests that the fund’s potential upside is often greater than the fund’s downside, which is how this fund has managed about 15% annualised returns over 5 years.

Summary
An examination of funds on Fundsupermart reveals fund managers can, through careful stock selection and a good amount of investment savvy, outperform the Ponzi scheme of the decade, which swindled investors through attractive, but ultimately illusory returns.

Unlike the Madoff hedge fund/Ponzi scheme masquerade, the unit trusts on Fundsupermart are strictly regulated and audited, and while there are no such things as guarantees in the investment world, one should note that for two funds at least, 10% annualised returns well within the realm of reality.

If you have any comments, questions or complaints about the article, feel free to drop a feedback post in our forum, or email me: nicholastay@fundsupermart.com