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Markets are in turmoil, stock values are plummeting and hundreds of unit trusts are losing money. It is a nightmare scenario for most investors, but particularly tough for the under-pressure managers of UK special situations funds.

The fact most of these portfolios are heavily exposed to the small and mid-cap areas of the market means they have been savagely hit by the toxic economic environment and the crisis afflicting a string of international banks.

The recent performance figures certainly do not make for pleasant reading. Even star names such as Derek Stuart, who runs the Artemis UK Special Situations fund, have struggled, according to figures compiled by Morningstar to 22 September.

Over the past year his portfolio is down 19 per cent – slightly more than the 18.3 per cent average for the IMA UK All Companies sector. But it is certainly not the worst and must be compared with other special situations funds to be seen in context.

F&C Special Situations, for example, is down 22.7 per cent over the same timeframe, while the S&W UK Special Situations fund has shed 28.5 per cent. The Rathbone Special Situations fund, meanwhile, has lost 42.7 per cent.

But although they have taken such a severe battering - and in many cases been forced to take refuge in defensive positions - observers maintain the current uncertain climate could eventually become a golden buying opportunity for these managers.

Andrew Merricks, head of research at Brighton-based Skerritt Consultants, has been advising clients to steer clear of such funds in recent weeks, but acknowledges that a number of them could soon be well-placed to cash in on the situation.

“There will be an indiscriminate sell-off of equities, but once this is over then certain stocks, and managers of special sits funds, will find themselves in strong positions,” he says. “It will be a great opportunity for them to make names for themselves.”

Rebecca O’Keeffe, head of fund management at Interactive Investor, agrees and suggests those canny enough to build up decent cash reserves over the coming weeks are likely to have a distinct advantage over their rivals.

“They should be well placed to weather the current storms,” she says. “Rather than having a benchmark linked to one particular asset class, these funds state that their aim is to exploit market conditions, which should give them additional flexibility.”

So how are the managers of UK special situations funds positioning their portfolios? Which stocks and sectors have they been looking to buy in recent months and which have they been selling as quickly as possible?

The volatility is certainly making life tough for investors, admits Royal London’s Derek Mitchell. The manager of the company’s UK special situations portfolio is one of a number that have opted for a strong defensive bias in their portfolios.

“You think something looks good value – and then the following week it is down a further 5-10 per cent,” he says. “There is certainly no point in trying to be clever and second guessing the market at the moment.”

Mr Mitchell admits that the portfolio lagged during August due to an overweight position in Oil E&P and Oil Services, which has since been reduced, while new holdings have been added in Whitbread, First Group and Smith & Nephew.

“These are all strong companies because you do not want any that have unnecessary gearing because when it comes to refinancing they could find it almost impossible,” he explains. “My aim is to keep it defensive at the moment.”

He also has money to spend as soon as the overall market environment looks more welcoming. “I have never been a fan of having cash and always preferred to be fully invested, but have about 4 per cent at the moment, which I can use on days when specific opportunities arise.”

Meanwhile, the priority for Carl Stick, manager of the Rathbone Special Situations fund, has been to move away from Aim-listed stocks and into the FTSE, but he admits progress has been slow due to illiquidity at the smaller end of the market.

In recent weeks he has exited his remaining holdings in both Topps Tiles and Lookers with balance sheet weakness being enough to convince him that both companies were likely to have trading difficulties in the current climate.

“We invested into larger, cheaper areas of the market,” he explains. “We bought BAT Systems, which enjoys superb revenue visibility and a very attractive valuation. We also re-entered BT where uncertainty over long-term prospects is more than discounted in a lowly valuation and an attractive dividend yield.”

Going up the market cap scale is also the approach taken by Sanjeev Shah, the manager of the Fidelity Special Situations fund. “The fund has recently had more exposure to large-cap stocks than it has for some time because they offered good relative valuations and visibility,” he explains. “However, with the sharp declines in the market and a broader spread of valuations than in the momentum-driven markets of recent years, I am also seeing more opportunities within the mid-caps.”

However, buying larger companies is not always an option. Angus Duncan, head of distribution at S&W, says his company’s UK special situations fund has suffered because of its orientation towards mid and small-cap names.

“It is a fairly harsh environment for this type of company – particularly those that require constant access to cash from banks,” he says. “Right now we are in waters that people have not yet chartered.”

This is also a concern for Richard Plackett, manager of the BlackRock UK Special Situations fund, who has to have at least 50 per cent of the fund invested in small and mid-cap names which, in times such as this, can be a serious drain on performance.

“I have been focusing on growth stocks in this area which have experienced management teams and strong barriers to entry,” he explains. “They also need to be cash generative so as not to have refinancing concerns.”

In addition, Mr Plackett has been increasing large-cap exposure to close to the fund’s 50 per cent maximum, and populated the fund with strong, stable, defensive corporate giants such as HSBC – one of the few global banks to still be looked on favourably.

Looking to the future, Fidelity’s Sanjeev Shah is certainly optimistic about the longer-term prospects for both his portfolio and the market as a whole, with an increasing number of opportunities expected to become available.

“I expect the credit crunch to have a deflationary impact and for inflation to ease going into 2009, which will lead to greater consumer spending power and the potential for cuts to interest rates,” he says. “This means I am very interested in the rate-sensitive sectors of the market, such as general retailers and real estate stocks.”

Which of these funds do advisers favour, therefore – and why?

The very fact that the “special situations” tag encompasses a vast array of different funds, each with their own names, biases and mandates, makes it a difficult task, according to Darius McDermott, managing director of Chelsea Financial Services

Therefore, sticking with managers that have proven track records is the key and he has three such names on his buy list: M&G Recovery; Axa Framlington UK Select Opportunities; and Artemis UK Special Situations. “They are all good, long-term UK investors,” he says. “It just so happens they are all in charge of special sits funds.”

Special situations managers in the UK are having a particularly difficult time at the moment, although there will be opportunities for contrarions in the near future to pick off some of companies that are struggling at the moment.

- Even so-called star managers are suffering terrible performance, particularly those that have restrictive mandates in place.

- The funds that are in the optimum position are those that have the freedom to invest where they choose in order to explout market conditions.

- Investors should look at the long-term track record of the fund and the manager before selecting a special situations fund.