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The Emperor Wears No Clothes Part 1: Should It Be

Lately, I’ve been reflecting on my experiences in the investment industry after having been forced (due to Arthur Andersen’s disintegration more than four years ago) from my 25+ year “home” in public accounting—a profession that, despite its recent blemishes, many of us view as principled, objective and truly committed to putting its clients’ interests first.

While many in this new-to-me world are principled (and many are not), some of the most well-meaning seem to accept common wisdoms that, frankly, make little sense—at least to me. In this and future columns, I will share some of my observations with you. I don’t pretend to have all the answers, but I hope that my questions and thoughts will stimulate your thinking and help you make better-informed decisions with your family’s and business’s investment dollars.

Necessary Disclaimers

The views expressed in these columns are mine and are not necessarily endorsed by this publication or my firm. Many people and companies in the investment industry will be incredibly upset by my comments. To them I say, “The emperor wears no clothes.” Some may argue my points, while others point fingers, but I often leave the discussions feeling unfulfilled.

I do not pretend to be an investment expert. Modern portfolio theory was created and developed by statisticians. Statistics was far and away my worst course in college. I recall my college professor saying that “you can prove anything with statistics.” However, I think that thirty years of success in the business world implies that I have some common sense. That is all I have to offer in the analyses that follow.

My First Impressions

During 2003, still wet behind my ears in my new field, I attended a major industry conference led by a recognized father of modern investment theory and practice. Keeping in mind that the conference occurred after the horrendous stock market bubble burst, his two keynote address themes, around which the entire conference was organized, were

  • Maybe investment professionals should consider their clients’ long-term objectives in making investment decisions, and


  • Perhaps investment professionals should reconsider whether it is possible to determine that stocks and markets are overvalued in determining how to invest clients’ money.

Industry professionals listened in rapt attention and debated whether and how they could follow through on these groundbreaking observations. Frankly, I was appalled that such basic questions could have only just come to the forefront of a mature industry’s thinking!


Diversification is a basic tenant of modern portfolio theory. I wholeheartedly believe in it. It is critical to reducing risk. Every investor during the dot-com bust and the Enron, WorldCom and other stock blow-ups earlier this decade understands that concentrating your portfolio in a limited number of companies or industries can lead to disaster. (Concentrating your wealth in a family business is a somewhat different matter. Please see my June 2004 column for further discussion.)

Diversification actually has two dimensions. First, you should diversify your assets among asset classes, like domestic and foreign stocks, bonds, hedge funds, private equity, real estate, etc. Second, you should diversify investments within asset classes.

Style Boxes

Let’s focus on diversification within the domestic equity asset class, aka stocks. Most players in the investment industry implement diversification through so-called “style boxes,” like growth and value.

Since style boxes seem to be at the core of how the industry operates, I wanted to understand the basics. So, I asked a simple question. “Who determines whether a stock is growth or value?” Interestingly, I have found few people in the investment industry who know the answer.

Digging deeper, I found the answer. Certain organizations create growth and value indexes. Money managers are typically evaluated based upon their performance relative to an index. For example, Barra (a company controlled by Morgan Stanley) splits companies between value and growth by calculating a fraction for each company. The numerator is the book value of the company and the denominator is the market value of the company’s stock. The half of the companies with the largest fractions is considered “value,” while the half with the lowest fractions is “growth.”

Now, I am an accountant. I think that I’m qualified to tell you that book value (the numerator) has virtually nothing to do with the future prospects of a company’s business. Current market value (the denominator) arguably has some relevance, but it is questionable whether current value tells you what will happen to its stock price in the future. My conclusion is that the growth/value division is essentially arbitrary and significantly flawed.

Why You Need Both Styles

Could this simplistic, yet widely accepted formulaic approach to diversification underlie some of the frustrating results that stem from its use? For example, statisticians love to analyze historical data for each style. They conclude that there is no rhyme or reason as to whether one style performs better than another in any given year or period of years.

Perplexed, the industry concludes that, since style-box performance is unpredictable, you need to have stocks from each style to be diversified. Doesn’t that seem circular? Maybe there’s no reason to be perplexed. Seemingly arbitrary groupings of stocks (e.g., by style) logically will perform unpredictably relative to each other! I don’t need a statistics degree to tell me that. But it begs the underlying question of whether style boxes make sense to achieve diversification in the first place.

Emphasis on Capitalization

Many industry players subdivide growth and value into large and small cap, meaning large companies and small companies based upon their total stock market capitalizations. So, we have large-cap growth, small-cap growth, large-cap value and small-cap value. Some further subdivide these categories. For example, you could have mid-cap companies, both value and growth. You get the picture.

Manager X decides to focus on large-cap stocks, while Manager Y focuses on small-cap companies. Does that make sense? In my former life, my accounting firm had experts in specific industries such as real estate, energy, and retailing. We never contemplated having experts based upon company size. A large automobile company is not very similar to a large grocery retailer. Yet the investment industry believes that the investment expertise is size—not industry—driven.

State of the Art

So, the state-of-the-art investment industry widely recommends that you pick a manager for each simplistically determined subgroup of stocks (growth or value) who is an expert based upon company size (not based upon industry).

The result? Statisticians analyze managers’ historical performances and conclude that it is very difficult to find managers who consistently beat their benchmarks. I’m not surprised. I think that at least some of the reasons are becoming pretty apparent.

Why do even well-intentioned managers agree to a “style” approach that seems to make so little sense? Well, it’s worse than that. If a manager refuses to use style boxes, or deviates from his style box (participates in “style drift”), he becomes a pariah and can be driven out of business almost regardless of his investment results. That’s a great segue into next month’s column. Please stay tuned.

Ross Nager is a senior managing
director of Sentinel Trust Company of
Houston, Texas





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