Investment Adviser., 7th November 2005

In the movie Robin and the Seven Hoods, the Rat Pack sing: “You either have or you haven’t; got style, and if you have it, it stands out a mile.” As this seems to have become the theme tune of the fund management industry, it is interesting to consider why this fashion should have arisen and its probable advantages or defects.

The first assumption of investors, and even more fund managers, is that good managers can outperform by selecting cheap shares. This raises two problems. Does history support the story and, if so, who is the patsy that underperforms so that other fund managers can have an edge?

History is unhelpful to fund managers. At least it does not suggest that past performance is a good guide to future achievement. Over any given period, half the fund managers seem to outperform the market and the number that does so consistently from one period to another is no different from expected number if performance were random.

Consistently good

This does not detract from the success of those who have achieved consistently good results and they will be amply rewarded. It just means that there is no way to judge, at least using past performance as the sole guide, whether they are rewarded for luck or skill.

Oddly enough, this feature does not point to the efficiency of the stock market but rather the opposite. Information is expensive. In a truly efficient market, the cost of research and fund management would be reflected in the difference between the average performance of the fund and tracker funds. This obviously assumes that indices are properly constructed. The evidence that share selection is difficult has provided a challenge. Since no fund manager can be really knowledgeable about all markets, it was assumed that they should specialise. The financial services industry has never lacked energetic people and the development of style managers has been the natural response to all this research. Style has had its set backs, due to the tendency for the theories to appear less robust with hindsight than they had with hope. Low price-to-earnings, small companies, return reversal and low price-to-book strategies are among the theories that surfaced, often to fall victim to time, which produces new evidence, or further work which casts doubt on the previous research.

Rolf Banz has been involved in both aspects. He was the first to discover the small company effect*. Andrew Lo and Craig MacKinlay note even more bizarre anomalies about the way small companies outperformed at different times of the year.


The existence of so many possible ways to outperform by approaches to investment which amount to different styles has been the foundation of the fashion. Unfortunately, they either seem difficult to implement in practice or have become the victims of additional research, which has given rise to skepticism about the original claims.

About the only theory of this sort, which seems to remain in place is the theory that low price-to-book shares will give superior performance. This seems to have been originally set out by Eugene Fama and Keith French. **However, there are two problems for low price/book investors. The first is that once an anomaly is identified it is liable to be exploited and disappear with its exploitation. But this takes time. The other is both a protection for the long-term future of the theory and a problem for its exponents.

It seems quite likely that low price/book shares underperform in buoyant times, but pick up their value in bear markets. The theory is likely to be most useful when it is hardest to persuade investors to back it and when they may be wise to avoid investing in shares at all.

Andrew Smithers is the founder of specialist investment adviser Smithers & Co. Ltd.

This article can also be found at Ft Adviser