Small and mid-cap stocks have been particularly hit by this increasing risk aversion and the subsequent sell-off, as some funds exposed to this segment of the market have witnessed important performance drawdowns and investor outflows.

The first conclusion to be drawn is that where asset managers seek extra performance from market risk factors (such as an exposure to small and mid-cap stocks), marketing documents as well as investor reporting should be explicit, pointing out the risks taken and explicitly disclosing where actual fund performance is coming from, using appropriate indices and relevant metrics.

The alpha must be representative of the excess return obtained in reference to an index through efficient stock selection and/or market timing skills, in comparison to a relevant benchmark. However, overperformance might also be generated through beta, for example, by modifying on a temporary basis the portfolio exposure to the evolution of the market in terms of sectors or styles. It must be clear to an investor what the inputs used to generate excess return are: does it come from successful active management or from new risk factors?

Some funds sold as “large-cap only” have been exposed to small- and mid-cap stocks. It is clear that, versus a large-cap index, if the fund holds a modest proportion of small and mid-caps, the mere passive exposure (beta) results in a significant overperformance (+26.30 per cent from December 2002 to May 2007 ). Thus, an overperformance versus the reference index should be attributed to a market size bias, rather than the fund manager’s talent (alpha).

Thus, lack of transparency has an impact on both investors and asset managers. In some cases, the former caused investors’ distrust because of product mis-selling. Conversely, it is of key importance for institutional investors to monitor thoroughly their risk exposure with regard to: the proper evaluation of the management value added, the constraints related to their balance sheet structure and the global consistency of their investment policy.

In Fitch’s view, best practice would demand:

• the choice of a reference index (not necessarily a pure index) consistent with the different risk factors the portfolio is exposed to;

• adherence over time to the chosen reference index;

• a display of specific risk adjusted performance;

• a display of several reference indices;

• a display of relevant breakdowns;

• stringent performance attribution to capture the alpha inputs by isolating specific effects.

A second conclusion is that the liquidity of a fund’s assets should always be consistent with the liquidity offered to investors, their investment horizon and granularity. Generally speaking, the liquidity of an asset is defined as the capacity for an investor to turn an asset into cash with no major impact on its price. As markets suffers their first serious liquidity crisis in 10 years, it is clear that the lack (or absence) of market counterparties can lead to sharp downturns. The liquidity issue for an open-ended fund is handled through an asset/liability management approach - adjusting the assets to the liabilities. Fund managers must be able to put up with a wave of redemptions (which cut the liabilities’ amount) by reining in, on very short notice, the assets held in the fund. However, liquidity risk contributors vary in regard of each asset type: physical constraints (real estate, commodities, infrastructures), lack of market depth (small- and mid-caps), counterparty risk (corporate bonds), contractual constraints (hedge funds) or lack of standardisation (over-the-counter instruments). Focusing on the small and mid-caps, the significance of in/outflows compared to the total market capitalisation and the valuation premium levels reached last year have clearly emphasised the liquidity squeeze.

When it comes to certain small cap stock pickers, potential threats can rapidly become reality: a few independent players turned out to hold significant stakes of the companies they invested in, a consequence of both a conviction-based management and of a significant increase in net subscriptions. Furthermore, concentrated funds heighten the effect of a sell-off on the whole portfolio leading managers to sell their most liquid holdings on very short notice, hence leaving the remaining fund shareholders with the least liquid stocks.

Some sectors - real estate, hedge funds and private equity - have already experienced such issues and developed some mitigants:

- a permanent cash cushion
- use of derivatives
- provision for gates, lock-up periods, notice periods
- launch of closed-ended funds
- alternative funding sources

Finally, investment transparency demands an exhaustive and accurate disclosure of risks in terms of sectors, style and liquidity; and that a thorough asset/liability management approach is of key importance in terms of liquidity.

Aymeric Poizot, head of Fitch Ratings’ EMEA Fund and Asset Management Group.