opportunities vehicles have had mixed results in the bear market but should outperform when the market definitively moves upwards
Few fund managers would describe their process as 'investing in disappointment' but that is how Derek Stuart of Artemis characterises special situations funds.
His strategy is to buy into sectors and shares that are temporarily out of favour with the market, perhaps because of a fall in share price or a change of management.
It is a contrarian stance that, if it works, should allow him to buy into quality stocks at a low price.
As such, it is hardly surprising that within the UK All Companies peer group special sits portfolios have produced a set of risk and reward characteristics very different from the average.
The UK All Companies sector over the three years to May 2003 has returned -26.81% bid to bid, with a beta of 1.0 and an annualised alpha of 0.49.
Contrast that to Artemis UK Special Situations run by Stuart. Not only is it up 52.55% but its alpha is 30.63 and its beta stands at 1.2.
Stuart sees the above average beta as a knock-on effect of some of his sector selection.
He said: 'I have been investing in banks, media and IT stocks throughout the past three to six months, which are high beta and these are holdings I have been previously underweight in.'
The launch timing of the fund proved fortuitous for Stuart. In March 2000 the market had crashed and he was able to invest cheaply in stocks that have since shot up.
Looked at on a discrete yearly basis, Stuart's fund got off to a roaring start. But in the year to the end of May 2003 it has been harder to make gains.
He said: 'Relative rather than absolute returns were being made over the past 12 months. All sectors were getting hit by the bear market and a selling frenzy set in. It is very difficult to make money when the market is coming down.'
The 12 months to May 2001 have proved to be the best period of returns for 12 of the 19 special sits funds identified by Investment Week.
The best return over the period was SVM's UK Opportunities fund, managed by David Stevenson, achieving 69.55% growth while Artemis' Special Situations fund was a close second at 67.74%.
The SVM vehicle has a positive return over three years to end of May, delivering 37.91%, on a bid-to-bid basis. Both the SVM and Artemis special situations funds had their biggest decrease over the 12 months to the end of May, delivering respective returns of -19.56% and -11.28%.
While Stuart's portfolio is an example of what can go right for investors by being different from the market, the track record of the Legg Mason Investments UK Emerging Fund demonstrates that different is not always synonymous with success.
This has produced the lowest returns over three years in the UK All Companies, at -76.48%, accompanied by the lowest annualised alpha at -21.76 while its beta was one of the highest at 1.48.
One special sits fund that has produced real returns for investors on a three-year view but with a below average beta is the £24.2m Rathbone Special Situations Fund run by Carl Stick.
During this period it returned 22.29% with a beta of 0.86 and an annualised alpha of 16.63.
Stick's emphasis since taking over the fund in February 2002 has been to explore the UK market ex-FTSE 100, and also to look at certain niche operations overseas.
He said: 'It invests in businesses which I believe the market has incorrectly valued. Currently the fund is about 95% invested in the UK, mainly smaller caps, where the research is not often as thorough, leaving good companies often overlooked.'
The fund traditionally has made its money from small-cap sector investment. Stick added, however, it has made money this year from Marvel, the US comic book company. Stick felt this stock was incorrectly valued. Following a number of high-profile successful films involving characters which Marvel own the rights to, he has seen good returns from his investment.
Asked about the fund's falling performance over the most recent 12-month period, Stick said: 'Investors associate more risk with smaller-cap investment as they feel it will be more affected by a downturn in the market over large caps. A special situations fund is not always going to reflect what is going on in the FTSE 100 and often the lack of liquidity does not help in small caps.'
First State's £15.2m British Opportunities fund has had disappointing returns in comparison to the sector average over the past few years. In the three years to the end of May, on a bid-to-bid basis, it achieved -49.19% against the sector average of -26.81%.
Over the past three years it delivered its best return during the 12 months to the end of May 2001 with -15.95%. In the following year, in line with sector activity, the performance declined once again, with a return of -22.43% but in the past 12 months to the end of May it achieved a very slight up-tick in its performance with a -22.07% return.
The fund's annualised alpha is very low at -7.82 against the sector mean of 0.49 while its beta is above average at 1.16. Derek Lygo, manager of the First State British Opportunities fund, took over its management in October 2001. He said: 'I am trying to choose stocks which are going to grow faster than the economy and identify companies that have the ability to outgrow GDP. I tend to find such companies in economically sensitive areas, like media.'
On the fund's poor returns, Lygo said all First State funds had been performing badly and the group had a pretty conservative investment structure in the late 1990s under the old team.
The fund got left behind in the tech boom as it invested into the sector at the wrong time in late 1999 when the bull run was coming to an end, he noted. As a result, it suffered all the downside of the sector but none of the upside, ultimately causing long-term damage.
Lygo said his policy is to always remain fully invested but he felt a substantial amount of his peer group were holding close to their maximum cash limit of 10% over the past year.
Another problem for the fund, according to Lygo, was the decision to put more beta in the fund in early 2002. Soon after the market fell drastically and the returns he had hoped for did not materialise.
He said: 'Currently I am holding economically sensitive stocks including cyclicals and financials which will benefit when conditions are good but in a bear market will tend to underperform.
I think we are moving to a more level playing field. In the past four months there has been some confidence returning to the UK market and I expect the fund to continue to improve.'
Senior Managers Regime
Interest rate outlook unchaged
FCA made demands last week
'Unsung' part of FSCS work