Special situations funds have outperformed the FTSE All-share by 33 per cent over the past five years and by 24 per cent over the past three.
“Special situations are the ultimate in active portfolio management,” says Rob Harley, fund analyst at independent brokers Bestinvest. “They tend to have a totally flexible investment mandate, which means that the manager can go anywhere in the market where he thinks there is value.”
As the name suggests, special situations funds tend to contain a diverse range of stocks which the manager thinks will present a good opportunity regardless of size or sector. The style of special situations managers varies, with some seeking out value and some taking a more pragmatic approach.
The challenge for investors, given the nature of the funds, is to select a manager whose style fits in with the asset allocation of the rest of their portfolio, as well as one with a good track record. This is not an easy task. While it is relatively straightforward to find out how a manager has done in his current job, it is more difficult to assess longer-term performance.
Citywire and Bestinvest both provide online services that allow investors to compare fund managers' records. Bestinvest produces a Manager Record Index (on www.bestinvest.co.uk) which examines the performance of fund managers throughout their careers and not just in their current jobs.
This is an important tool when choosing a special situations fund because managers move frequently and their investment philosophies vary widely. The best known special situations fund is Fidelity's, run by veteran fund manager Anthony Bolton. The £3.8bn fund invests mainly in the UK, and Bolton, a value investor, uses five main categories of stock selection:
■ Companies in a turnround or recovery situation.
■ Companies with unrecognised growth potential, for example where growth in a subsidiary or due to a complex corporate structure is not well understood.
■ Companies trading below asset value.
■ Companies with “corporate potential”, for example, which may be takeover targets.
■ Companies that look unjustifiably cheap compared with their rivals.
The broad categories suggest that Bolton has plenty of leeway in selecting the 190 stocks that his portfolio holds, a flexibility that has paid off in terms of performance. Over the 12 months to August 31, the fund was up 17 per cent against an index rise of 11 per cent.
Derek Stuart, who manages Artemis's £450m UK Special Situations fund, says he likes companies “where there is a lot of turnover but not a lot of profit”, and where management change is likely to bring about significant margin improvement. Like all special situations fund managers, Stuart focuses more on qualitative assessments such as company meetings than quantitative screening in his stock selection process.
The fund has 60 per cent in small and mid cap stocks and about 15 per cent in the oil and gas sector. Stuart says he has a bias towards small and medium-sized companies because they are “more interesting and more under-researched”. He often focuses on unfashionable stocks or sectors such as housebuilding and construction towards the end of the technology boom in 2000.
The fund was up 15 per cent in the 12 months to August 31 compared with a FTSE All-Share rise of 11 per cent. Such performance comes at a price, and these funds tend to have higher turnover and charges than average.
The Artemis fund and Jupiter's £146m European Special Situations fund have a preliminary charge of 5.25 per cent and an annual management fee of 1.5 per cent. Leon HowardSpink, manager of the Artemis fund, says he finds the “special situations” label somewhat misleading. “In the minds of investors and IFAs special situations means high-risk speculative investments like takeover targets,” he says. He argues that his fund is actually a low-risk one with the flexibility to go “off index”.
HowardSpink's approach is driven by stock selection opportunities rather than a top-down view of a country or region. This has led to interesting anomalies. “It's been difficult to find entrepreneurial companies with a solid track record in Germany,” he says, which has led to a generally underweight position in the country. His stockdriven approach is echoed by other special situations fund managers. Their somewhat unconventional style means investors must be prepared to do some research when selecting a fund. Hedge funds, Page M3