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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
KB Kee is the Managing Editor of the Moat Report Asia (www.moatreport.com), a research service focused exclusively on highlighting undervalued wide-moat businesses in Asia; subscribers from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing. KB has been rooted in the principles of value investing for over a decade as an analyst in Asian capital markets. He was head of research and fund manager at a Singapore-based value investment firm. As a member of the investment committee, he helped the firm’s Asia-focused equity funds significantly outperform the benchmark index. He was previously the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. KB has trained CEOs, entrepreneurs, CFOs, management executives in business strategy, value investing, macroeconomic and industry trends, and detecting accounting frauds in Singapore, HK and China. KB was a faculty (accounting) at SMU teaching accounting courses. KB is currently the Chief Investment Officer at an ASX-listed investment holdings company since September 2015, helping to manage the listed Asian equities investments in the Hidden Champions Fund. Disclaimer: This article is for discussion purposes only and does not constitute an offer, recommendation or solicitation to buy or sell any investments, securities, futures or options. All articles in the website reflect the personal opinions of the writer.

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