Murphy's Law and Market Anomalies

Elroy Dimson and Paul Marsh, August 1998, London Business School Working Paper (forthcoming in Journal of Portfolio Management).


The vanishing size premium has not escaped the notice of academics. In this article, two of the first authors to write about this phenomenon in Europe put forward their views on recent events. What caused this disappearance? A comprehensive set of explanations are discussed and mostly dismissed. The fact that small company indices have a very different industry make-up than larger cap indices certainly plays a role. More fundamentally, small cap stocks have in the past 10 years lagged well behind their larger brethren in generating cash flow growth. The authors leave the door to future research generously open, concluding that - according to Murphy's Second Law - nothing is ever as simple as it seems.

Firm Size and Cyclical Variation in Stock Returns Gabriel Perez and Allan Timmermann, Federal Reserve Bank of New York and University of California San Diego working paper, October 1998.

Academic researchers spent a lot of time in the 1980s and early 1990s telling us about the 'size premium'. Small company stocks, it appeared, consistently earned higher returns than large companies. Confusingly, the phenomenon now seems to have reversed. In the last decade, UK smaller companies have underperformed the broad market by around 6% per year. In the US the size premium was noticed earlier and disappeared sooner. Since 1984 US small stocks have lagged big stocks by around 2.5% annually. The authors of this paper believe we should expect the size premium to vary through time, in particular with changes in the economic cycle. They find that the link between firm size and expected stock returns is strong during recession but not very important during economic expansion. Small companies - with constrained access to investment financing - appear to be far more exposed to worsening credit market conditions than large firms. The econometrics in this paper can at times be a bit daunting, but the intuition is appealing.

Global Asset Management

Bruno Solnik, The Journal of Portfolio Management, Vol. 24 No. 4, Summer 1998, pp.43-51.

One of perhaps only a handful of leading financial academics with a truly global perspective, Bruno Solnik excels at explaining international investment theory in intuitive terms. In this article, he considers how institutional investors should deal with currency risk. Should currency exposure be hedged and, if so, by how much? Theory suggests the best approach is to hedge only a portion of long-term currency exposure. Real world complications make determining this optimal level very difficult. If you are truly a long-term investor - with a horizon of 50 years or more - Solnik argues the best approach may be no hedging at all. This does not mean currencies can be ignored, quite the opposite. Solnik suggests any pension fund that believes in active management should make currencies an integral part of their tactical allocation process.

Kevin Coldiron is head of European research, Barclays Global Investors in London