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Monkeys Are Better Stockpickers Than You’d Think; Why dart-throwing primates demolish S&P 500 returns and most active fund managers don’t even come close

Monkeys Are Better Stockpickers Than You’d Think

Why dart-throwing primates demolish S&P 500 returns and most active fund managers don’t even come close.

JACK HOUGH

Updated June 19, 2014 4:14 p.m. ET

“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,” Burton Malkiel famously argued in his classic 1973 book, A Random Walk Down Wall Street.

Malkiel may have given too little credit to monkeys.

Start with the record: U.S. large-company mutual funds have routinely failed to beat the Standard & Poor’s 500 index since S&P began keeping score in 2002. Over the past five years, for example, 73% of active funds have fallen short of that benchmark. Today’s fund families may appear well-stocked with winning funds, but that’s in part because 26% of U.S. stock funds were merged or closed during the past five years.

Now consider that the S&P 500 isn’t a good proxy for the stock-picking prowess of monkeys. Most of them, given enough darts, would have clobbered the index in recent years. That’s because the S&P 500 weights companies by market capitalization, or the cost to buy all of their shares. Large companies have the most sway in determining returns. Monkeys don’t care for cap-weighting; they prefer to equal-weight companies as their darts find their mark.

A March study by London’s Cass Business School found that among 10 million randomly created indexes, each with 1,000 U.S. stocks in equal weights (that is, monkey portfolios), nearly all of them beat a cap-weighted index from 1968 through 2011.

In a recent report, Tim Edwards and Craig Lazzara at S&P Dow Jones Indices point out that the S&P 500 Equal Weight index has returned 9.1% a year over the past 15 years, beating the S&P 500 cap-weighted index by a whopping 4.6 percentage points a year. One reason might be that an equal-weight index avoids plumping up exposure to market pockets where prices are rising the fastest—like dot-com shares in the late 1990s, before the 2000 tech crash.

Compare active funds with an equal-weight index, which arguably is more representative of the choices stockpickers face, and the results go from bad to worse for fund managers. Two reasons: Fear of underperforming peers keeps most fund managers hugging the cap-weighted S&P 500 with large portions of their portfolios, erasing the equal-weight advantage that monkeys have long enjoyed.

Edwards and Lazzara find that the relatively small number of fund managers who stray far from the S&P 500’s weightings have posted the best returns—but they caution that these truly active stockpickers are only as good as their picks. The second reason is fees, which are typically higher for actively managed funds than for index funds.

The paper clears up another mystery. S&P 500 Pure Growth and S&P 500 Pure Value, indexes that track stocks with opposing sets of attributes, have both beaten the S&P 500 over the past 15 years. But that’s because they don’t use cap-weighting. Comparing them with the 500 Equal Weight index shows that Value did better and Growth did worse.

Key Takeaways
More mutual-fund investors should choose cheap index funds over pricey active funds. That’s a familiar refrain to many, but 87% of fund money is still under active management. Among fund holders who choose active management, benchmark-straying is a necessary (but not sufficient) condition of success (see Barron’s, Cover, “Is Your Fund Manager Active Enough?,” Jan. 14, 2013).

Alternatives to cap-weighted index funds are worth a look. Equal-weight ones, like Guggenheim S&P 500 Equal Weight exchange-traded fund (ticker: RSP ), tend to have increased exposure to value stocks and smaller companies than cap-weighted 500 funds, and different sector allocations—less in tech and health care at the moment, and more in utilities and industrials. There are also funds that weight stocks by fundamental factors like cash flow and dividends, including Schwab Fundamental U.S. Large Company Index Fund ( SFLNX ), which achieves the value tilt without the smaller-company emphasis.

 

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About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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