INVESTMENTS

There are times the stock market can be a tough and demanding taskmaster. Just when you think that you have found the key to achieving above-average performance, your fail-safe method suddenly ceases to work. In economics, they have known for years about Goodhart's Law, which lays down that any economic indicator on which the authorities choose to put heavy emphasis in framing monetary policy will immediately cease to behave in its traditional manner.

But until recently, not so many people were aware that something similar applies in the stock market, too. The latest example of this phenomenon is the so-called "small companies" effect. Any finance text book will tell you how one of the "anomalies" in stock market behaviour is the tendancy of small companies to outperform larger ones, even after allowing for the additional risk involved.

The reason this is an anomaly is that, according to the theory of efficient markets, it is not a phenomenon you would expect to see recurring for any length of time. If small companies consistently provided what academics call "excess returns" (ie they outperformed the market as a whole on a risk-adjusted basis), then you would expect supply and demand to see to it that this did not last. The flock of buyers into the sector would push prices up and lead to smaller companies being valued more highly - until the scope for outperformance had in effect disappeared.

So much for the theory, which can be best summed up in its vernacular form as "there is no such thing as a free lunch in the stock market". The reason it is worth recalling now is that the small company effect, which was an observable phenomenon, seems to have disappeared in the last few years.

The evidence for this comes from Hoare Govett Smaller Companies Index, a review of the way that the smallest quoted companies on the London Stock Exchange perform over time. It has been compiled for a number of years by two highly regarded academics at London Business School, Elroy Dimson and Paul Marsh. Their latest annual review of the index's performance was published this week.

What it shows is that the smaller companies effect is now in full-scale retreat. In the 41 years since 1955, when the data series began, the Smaller Companies Index has outperformed the All-Share Index 29 times, frequently by a handsome margin. The cumulative excess return over the whole period is just under 4 per cent per annum. The figures are: All-Share - annualised total return from 1955 to 1995 inclusive 14.2 per cent; Smaller Companies - 18 per cent. To provide a statistically fair comparison, the figures combine capital gains and dividend income, which is assumed to have been reinvested.

But the experience of recent years has been very different. The stockbrokers Hoare Govett started to publish the index on a regular basis in the mid- 1980s. For a while all went well. Smaller companies continued to outperform in 1987 and 1988. But in the next four yearssmaller companies underperformed bigger rivals, and while 1993 was a good year for the minnows, last year was one of the worst of all time. The total return on smaller companies in last year's bull market was nearly 10 per cent below that achieved by the All-Share Index.

Just as interesting is what has happened to the volatility of smaller company shares. Volatility, the extent to which prices fluctuate around their long-term average, is a measure of risk. Over the whole period 1955 to 1995, smaller companies not only outperformed their bigger brethren, but did so without involving investors in any significant extra risk. In fact, they were if anything less volatile. As long as investors hold a diversified portfolio of small company shares, the smaller company sector held out the promise of the investor's Holy Grail: higher return for lower risk.

But even that part of the story seems to be losing its lustre. The volatility of the smaller company index has also increased, to the point where it is marginally more volatile than the All-Share index. So now the prospectus seems to be: a lower return and higher risk. That, if it turns out to be new trend, is hardly the most appealing of combinations.

Spare a thought too for all the fund management companies that have launched unit trusts and investment trusts to cash in on the "small companies effect". They must be cursing the market's fickleness, although they cannot be entirely surprised at the turn of events. The fact that the effect has become so well known must be, as efficient markets theory suggests, one of the reasons it no longer works. Another explanation is that smaller companies are better researched and easier to trade than they were years ago.

But before anyone gets too gloomy, it is worth keeping the business in perspective. All such statistical exercises are just that. The composition of the smaller companies index has changed dramatically over the years, reflecting changes in our corporate landscape, so comparisons need to be treated with care. The arrival of the privatised utilities, for example, has tilted the performance scales towards larger companies. The smaller companies index is also relatively top-heavy in sectors such as property and construction, which have struggled.

In other words, it is not difficult to find explanations for the reversal of fortune. Reading between the lines of Dimson and Marsh's latest offering, it is possible to deduce that one bright spark for the sector may be the prospect of takeover activity. The current wave of bids and deals has been largely confined to bigger companies. History suggests it may be the smaller companies' turn next.

But the main worry about the "small companies effect" must be that its disappearance is not widely enough known. Only when we have read its obituary several times can we be sure that it is finally about to return to its former glories.