Author Topic: Monkeys Are Better Stockpickers than...market-cap weighted Indexes  (Read 1076 times)

FrugalFisherman10

  • Stubble
  • **
  • Posts: 180
Since we pretty much all are invested in market-cap weighted indexes, I found this study from the Cass Business School in London particularly compelling.  Basically they found that a random group of 1,000 stocks, weighted by 'fundamentals', would beat market-cap weighted indexes almost every time.
"We programmed a computer to randomly pick and weight each of the 1,000 stocks in the sample; we effectively simulated the stock-picking abilities of a monkey. The process was repeated 10 million times over each of the 43 years of the study.

"The results of this experiment showed that many of the monkey fund managers would have generated a superior performance than was produced by some of the alternative indexing techniques. However, perhaps most shockingly we found that nearly every one of the 10 million monkey fund managers beat the performance of the market cap-weighted index."

On this forum I've seen IndexInvestor (i think that is his/her handle), Tyler, amongst others discuss many aspects, downfalls, suggestions, etc. around market-cap weighting of indexes. Alot of it goes over my head but I'd like to see what everyone's thoughts are on this study.

Here's the links:
http://www.cass.city.ac.uk/news-and-events/news/2013/april/monkeys-beat-market-cap-indices
http://www.cassknowledge.com/sites/default/files/article-attachments/evaluation-alternative-equity-indices-part-1-cass-knowledge.pdf
http://www.cassknowledge.com/sites/default/files/article-attachments/evaluation-alternative-equity-indices-part-2-cass-knowledge.pdf

3.2.3 Summary
Taken together, the risk ratios indicate that over this sample period investors would have
received superior risk-adjusted returns from any of the fundamentally-weighted indices
considered here compared to the Market-cap index
. The best risk-adjusted performer was
the Sales-weighted index, which also produced a Sharpe ratio that was significantly different
to that of the Market-cap benchmark.

markbike528CBX

  • Bristles
  • ***
  • Posts: 491
  • Location: the Everbrown part of the Evergreen State (WA)
Re: Monkeys Are Better Stockpickers than...market-cap weighted Indexes
« Reply #1 on: August 04, 2017, 08:39:06 AM »
As an initial picking/buy technique I could see this working well.  The costs and complexity of maintaining such a fund would tend to reduce the value of the idea.

  I think Bogle started out wth an equal weight fund before his market cap idea breakthrough.

  If you pick by any criterion, and then hold, the fund you've created will tend to become a market cap weighted fund.

AlienRobotAnthropologist

  • 5 O'Clock Shadow
  • *
  • Posts: 81
Re: Monkeys Are Better Stockpickers than...market-cap weighted Indexes
« Reply #2 on: August 12, 2017, 03:25:27 PM »
Extremely interesting papers! This answers some questions I've had for a long time but could never get satisfactory answers to. I'm not sure how actionable this currently is but it's at least very theoretically satisfying.

kenaces

  • Stubble
  • **
  • Posts: 187
Re: Monkeys Are Better Stockpickers than...market-cap weighted Indexes
« Reply #3 on: August 12, 2017, 10:53:23 PM »
Meb Faber talks about this all the time on his podcast.  There are many EFTs that use weights other than market cap.  I think one can can argue it is just another way to tilt portfolio toward value.

Telecaster

  • Pencil Stache
  • ****
  • Posts: 891
Re: Monkeys Are Better Stockpickers than...market-cap weighted Indexes
« Reply #4 on: August 12, 2017, 11:04:13 PM »
Meb Faber talks about this all the time on his podcast.  There are many EFTs that use weights other than market cap.  I think one can can argue it is just another way to tilt portfolio toward value.

Or more towards mid-caps.  I read somewhere that most of the gains are made by a small number of stocks.  With cap weighting, your weighting your bets on the stocks with highest market cap.  So with equal-weight, you are actually placing bigger bets on more stocks. 

Rubic

  • Pencil Stache
  • ****
  • Posts: 823
Re: Monkeys Are Better Stockpickers than...market-cap weighted Indexes
« Reply #5 on: August 13, 2017, 10:14:43 AM »
Here are a couple articles about Guggenheim's S&P 500 Equal Weight ETF (RSP):

    http://www.investopedia.com/news/venerable-equalweight-etf-rsp/

    http://www.investopedia.com/news/equalweight-etf-lower-fee-rsp/

Not recommending RSP, just providing links for discussion.

kenaces

  • Stubble
  • **
  • Posts: 187
Re: Monkeys Are Better Stockpickers than...market-cap weighted Indexes
« Reply #6 on: August 13, 2017, 10:20:55 AM »
Meb Faber talks about this all the time on his podcast.  There are many EFTs that use weights other than market cap.  I think one can can argue it is just another way to tilt portfolio toward value.

Or more towards mid-caps.  I read somewhere that most of the gains are made by a small number of stocks.  With cap weighting, your weighting your bets on the stocks with highest market cap.  So with equal-weight, you are actually placing bigger bets on more stocks.

Depends on which ETF you use.  There are lots of ways to move away from market weighted funds/ETFs.

Tyler

  • Handlebar Stache
  • *****
  • Posts: 1046
Re: Monkeys Are Better Stockpickers than...market-cap weighted Indexes
« Reply #7 on: August 13, 2017, 10:50:29 AM »
Yeah, the thing about market cap weighted funds is that despite the company count in the fund the returns are mostly driven by a relatively small number of large companies.  For example, even though VTI holds shares in more than 3500 US companies, the top 50 companies represent about 40% of the fund.  So they're really a lot less diverse than you think, and they arguably have a strong winners bias where company growth doesn't really influence fund returns until that company has already gotten truly massive relative to all the rest. 

That said, I do like how market cap weighted funds tend to be very low cost.  A common problem with alternative index research (value, momentum, etc) is that the returns using a certain filter may look terrific in theory but the internal trading costs for buying and selling companies that meet the filter can exceed the ER by an order of magnitude.  I did notice that the research in the OP does mention trading costs (which I find refreshing), although I personally think they dismiss the effects too quickly with not enough supporting data of just how high trading costs really are.  Toss in tax implications of regular fund trading (especially in momentum strategies) and the higher average ERs of "smart beta" funds and it's even worse.  So the academic returns often have a practical limit that the researchers do not understand but that traders would immediately recognize as a dealbreaker. 

Personally, I'm fond of a relatively simple method of approximating an equal weight fund using two low-cost market weighted funds -- VTI and VB.  By purchasing 50% of each, the total stock portfolio is pretty evenly distributed among large, mid, and small caps and also among value, blend and growth companies.  Look at the Morningstar style box distributions for each, and you'll see what I mean.  (VTI, VB)
« Last Edit: August 13, 2017, 12:33:33 PM by Tyler »
Browse portfolios calculated for your own home country at PortfolioCharts.com

Maenad

  • Stubble
  • **
  • Posts: 106
  • Location: Minneapolis 'burbs
Re: Monkeys Are Better Stockpickers than...market-cap weighted Indexes
« Reply #8 on: August 14, 2017, 09:38:17 AM »
I did notice that the research in the OP does mention trading costs (which I find refreshing), although I personally think they dismiss the effects too quickly with not enough supporting data of just how high trading costs really are.

Plus, most actively-managed funds have ERs based on AUM (assets under management), so it's not just the cost of the trades. It looks like the average returns of their "monkey funds" were at most 2% higher than the market-cap weighted (I'm looking at Table 2 of Paper 1). Add a 1% ER to that, and I'm not impressed so far.