The Evidence-Based Investor

Monkeys really do make better investors than humans

Posted by Robin Powell on March 7, 2017

It was Burton Malkiel who famously said in his his 1973 bestseller, A Random Walk Down Wall Street, that “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.”

But, after costs, assuming he only gets paid in bananas, our visually challenged primate friend wouldn’t only beat most active investors but most passive ones as well.

Let me explain. Those clever people at Cass Business School have been looking at different ways of constructing an index. Back in 2011, a team led by Andrew Clare published research on the then relatively new phenomenon of “smart beta”, or  alternative equity indexing as Clare and his colleagues prefer to call it. Their research demonstrated that, for the period from 1968 to 2011, all of the smart beta approaches to US equity investment they explored produced superior risk-adjusted returns to those generated by a comparable, market capitalization-weighted US equity index.

In 2015 Clare, together with Nick Motson and Stephen Thomas, published research which showed that even an index based on Scrabble scores would have beaten a cap-weighted US index fund over 50 years.

Last year, 2016, was the Chinese year of the monkey. So, for a bit of fun, but also to make a serious point, the Cass team looked at how, over the calendar year, the returns delivered by randomly generated stock indices (as if chosen by a monkey), compared to a market cap-weighted index.

Using a common set of 500 US stocks, they analysed the performance of 1 billion — yes, billion — different indices. The upshot: 67% of randomly-generated indices produced a higher risk-adjusted return than the cap-weighted index.

Is this a reason not to use cap-wighted index funds? Absolutely not. Cap-weighting is arguably the purest form of passive investing. It’s beautifully simple, and it’s because it keeps trading to an absolute minimum that cap-weighted funds are so cheap and such good value for money. As the SPIVA data produced by S&P Dow Jones Indices shows time and time again, only a tiny number of funds are able to beat the cap-weighted index over any meaningful period of time.

What the Cass research does however remind us is that, despite the huge outflows from active funds in recent years, the big index fund providers should not be resting on their laurels. Innovation in asset management usually benefits the industry more than the consumer. But that’s not to say that the likes of Vanguard should continue doing things a certain way done just because that’s the way they’ve always done them.

There are alternative ways of constructing an index that may, in many cases, be a better option for investors. I personally think there’s much to be said, for example, for equal weighting and maximum-diversification weighting, but that’s a discussion for another day.

In any event, the Cass research is very bad new for active managers. After all, the vast majority have shown themselves incapable of consistently outperforming an index which, on average, would underperform an index designed my monkeys. How embarrassing is that? And if those active managers think it’s tough delivering value now, just wait till indexing really gets its act together.

 

Related posts:

The Scrabble index — and why it spells trouble for active managers

Sorry, active managers — indexing will get even better

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Robin Powell

Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector. Regis Media.

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