Feb 13 2012

Is it now the time for special sits to shine?

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There are currently 21 special situation-named funds listed within the IMA sectors, with the majority of these – 10 to be specific – sitting in the IMA UK All Companies sector.

Eleven special situations funds were launched in the 10 year period between 1998 and 2007, which covered the rise and end of the TMT bubble and the build up to the current financial crisis, with six appearing in 2005 and 2006.

However, the fact that these types of funds are spread across the UK Smaller Companies and UK All Companies sectors, as well as North America, Global and Europe excluding UK, means comparing them like for like can be difficult.

Perhaps unsurprisingly the volatility in the market in 2011 meant of the 21 special situations funds that you would expect to produce uncorrelated returns, only five recorded a positive return, led by the £748.5m CF Miton Special Situations run by Martin Gray, which returned 2.93 per cent for the year to January 25.

This fund sits in the newly created IMA Mixed Investment 40-85 per cent Shares sector, and its performance contrasts strongly with that of the £1.35bn Fidelity Global Situations fund, which lost 15.64 per cent over the year. Last month saw the departure of manager Jorma Korhonen, to be replaced by Jeremy Podger from Threadneedle.

The average performance of special situation vehicles in 2011 was a loss of 5 per cent, and although only five funds made positive returns, 10 actually beat the average.

Meanwhile over five years to January 25 the disparity between the best performing and worst performing funds is even wider, with the £194.55m Liontrust Special Situations fund posting an impressive 51.29 per cent compared with the MFM Techinvest Special Situations fund, which sits in the UK small caps sector and posted a loss of 45.6 per cent over the same period, according to Morningstar.

One of the possible differentiators in performance of these funds, which in theory all aim to do the same thing, is the way they allocate their portfolios, particularly in terms of the size of the companies in which they invest.

The Liontrust vehicle, run by Anthony Cross and Julian Fosh, has its largest weighting in the FTSE 100 at 40.2 per cent of the portfolio, as of December 31 2011, with a further 22.29 per cent in the FTSE Mid 250 but with 18.2 per cent in FTSE Aim stocks, balancing the portfolio between mega and micro caps.

In comparison, the £1.9m MFM Techinvest Special Situations fund has approximately 80 per cent in micro caps and 18 per cent in small caps, eschewing the mid to large cap areas of the market. Perhaps this is to its detriment: of the other three special sits funds posting negative five year performance figures, the second highest loss was 10.76 per cent recorded by the Halifax Special Situations fund. Looking at the breakdown of the vehicle the Halifax fund had 19 per cent of its portfolio in small and micro caps, although the rest was fairly evenly distributed, with the fund’s highest weighting of 44 per cent in mid caps, according to data from Style Research.

But for the three years to January 25, as markets began to recover from the shock of the financial crisis, unsurprisingly the special situation funds in the IMA UK Smaller Companies sector boomed, with the £14.47m Close Special Situations fund, run by Deryck Noble-Nesbitt, producing a massive 256.19 per cent return, with a portfolio of more than 60 per cent micro caps and 30 per cent small caps.

In such an environment even the MFM Techinvest Special Situations performed well, with a 33.08 per cent return. Bringing up the rear was the CF Miton Special Situations portfolio, with a return of 19.1 per cent for the three years, well below the three year 63.74 per cent average of those with a three year track record.

Ben Seager-Scott, senior research analyst at Bestinvest, says: “Generally, special situations funds will be multi-cap, and within that I would typically expect the large cap to provide some ballast and a bit of growth, while the primary growth drivers (and risk) are more likely to be the mid and small-caps component.”

But while portfolio allocation may have had a bearing on performance, it is also one of the sectors where fund size is less important.

The largest fund, the £2.22bn Fidelity Special Situations vehicle, returned 2.43 per cent for five years and a loss of 11.25 per cent in 2011. The £8.12m Neptune UK Special Situations fund, which passed its five year anniversary in December 2011, returned 18.01 per cent over five years and posted one of the smallest one year losses of 1.17 per cent.

Manager Alex Breese says: “I suppose special situation funds by their nature tend to have quite a heavy bottom-up focus and they also tend to be focusing more on companies that are in the kind of recovery phase or perhaps being turned around.

“The market environment we have today is a good hunting ground for those kind of ideas. The economic environment is difficult in developed world economies and therefore there are lots of subsectors and companies that have had a very tough time and perhaps are now in a position where they might be starting to recover.”

However he points out whatever the economic cycle there are always companies that are involved in special restructuring situations for various reasons, such as the replacement of a management team.

“If we can identify those companies that are going to do well because of internal self-help, then that’s probably going to be a good place to be invested over the next few years.”

That said, he admits an area where perhaps such companies do less well is in an environment driven by macroeconomic concerns, where investors are looking less at the individual company fundamentals and more at the big picture.

“They’re just looking for defensive companies or they’re looking for very, very cyclical companies and they’re moving portfolios around on those criteria and slightly bypassing the bottom-up side of things.

“That kind of environment can be harder for a special situations manager. Last year there was a lot of value in the market that wasn’t recognised and investors were very much playing it safe.”

But Mr Breese agrees the variety of funds in the sector, ranging strategies focused on the largest stocks in the FTSE All Share to small and mid caps specifically, means it is difficult to judge them as trying to do the same thing.

“It’s very subjective: what is a special situation? I’m sure if you spoke to all of the managers one by one they would all have different definitions of what is a special situation for them,” he argues. Mr Seager-Scott adds: “To be a true ‘special situations’ fund, I’ve always looked for the three C’s: contrarian, conviction and catalyst. It’s a bit cheesy, for often special situations will be out-of-favour or not fully appreciated stocks, making them contrarian. I also want to see that the manager has conviction in his stock picks and that there is a catalyst for the stocks to realise their value.”

Nyree Stewart is deputy features editor at Investment Adviser