While a small proportion of active fund managers have demonstrated the ability to consistently beat the market, the evidence is weak for active fund managers as a whole consistently beating the market, especially on an after-fee basis. This means that it is crucial for research houses to have the right skills and processes in place to identify the active managers that will outperform.
Interestingly, there are anomalies in the stockmarket that have persisted over time. Many stud- ies have shown that cheap (low price-to-earnings or low price-to-book value) stocks generally beat expensive stocks over the long run, leading to something termed the “value premium”.
Another effect which has held up over time is that small-cap stocks generate greater returns than large-cap stocks over longer periods – although many argue that this isn’t really an anomaly, as smaller-cap stocks are usually higher risk. Also, stocks that have recently risen often continue to keep rising in the short term – something termed price momentum.
Many other reported anomalies exist, although trading costs and liquidity may stop them from being exploited effectively. Additionally, most of these anomalies are empirical findings, meaning they have been identified from historical data. They often have no proven, theoretical basis and hence cannot be guaranteed to recur in the future, especially if people continually exploit them.
Behavioural finance has attempted to reason these anomalies as being caused by human biases, although there is little way to prove it beyond doubt. While biases may exist at the individual level this doesn’t necessarily mean that those biases should present themselves at the market level if there are enough people exploiting them – that is, arbitraging them away. If the anomalies are indeed caused by behavioural biases then they should persist.
Strategies such as fundamental indexing, which use alternative, fundamentally-based methods of weighting stocks in a portfolio, try to capture value from these anomalies. Meanwhile, many quantitatively-based strategies use price momentum as an input into the investment process, trying to capture the premium associated with that.
While there is still much debate about the effect of behavioural biases on the stockmarket, benefits can be gained from understanding human behaviour and how to incorporate it into financial practice.
Understanding fundamentally how people think represents a great leap forward in “knowing your client”.
Aniket Das is a rating analyst with Standard & Poor’s Fund Services.
