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article image'Monkeys' make better investment decisions than fund managers

By JohnThomas Didymus     Apr 5, 2013 in Business
Researchers using a computer to simulate the stock-picking behavior of a monkey found that "monkeys" outperform traditional market capitalization-weighted index designed to mirror the market.
Researchers at the Cass Business School evaluating alternative approaches to determining constituent weights of equity indices found that even a random choice of constituent weights (a "monkey portfolio" as investment experts call it) often produced a superior performance than passive exposure to a market capitalization-weighted index.
The Cass Business school study created 10 million "monkey" fund managers by programming a computer that randomly weighted 1,000 stocks. Using monthly US share data from 1968 to 2011 43 years, they found that nearly all of the monkey managers gave returns significantly superior to a market cap-weighted index where the percentage of the stock in an index is weighted according to the size of the firm
City A.M. reports Professor Andrew Clare, co-author of the study, said: “Nearly every one of the 10 million monkey fund mangers beat the performance of the market cap-weighted index. We should perhaps be benchmarking our fund managers against monkeys rather than against a cap-weighted index."
However, before you make the move to fire your fund manager and replace him with chimps in suspenders, the study also found that some alternative indices will outperform your chimp fund manager 99 percent of the time.
The first part of the study: "An evaluation of alternative equity indices. Part 1: Heuristic and optimized weighting schemes" considered two categories of index construction techniques:
Heuristic - simple techniques based on a rule of thumb
Optimised - techniques involving more complex optimisation procedures
The researchers found that in the period 1968 to 2011, the alternative indices gave a better risk-adjusted performance than a market capitalization-weighted index.
According to City A.M., Dr. Nick Motson, co-author of the study, said: "All of the 13 alternative indices we studied produced better risk-adjusted returns than a passive exposure to a market-cap weighted index."
The second part of the study: "An evaluation of alternative equity indices. Part 2: Fundamental weighting schemes," investigated another approach to index construction termed Fundamental Indexation. The study examined the performance of equity indices based on weighting schemes employing:
Total dividends paid by a company;
Each company's total annual cashflow;
Each company's book value;
Each company's total annual sales
and a combination of the above alternatives.
The results showed that alternative indices based on fundamental indexation approach out-performed passive exposure to a market capitalization-weighted index. The irony is that in spite of the fact that alternative indices outperformed the market-cap index, the "monkey porfolios" outperformed many of them (i.e. the alternative indices).
However, the study found that alternative indices where stocks were weighted according to company's annual sales beat the chimp fund managers 99 per cent of the time.
The study was designed to evaluate so-called "smart beta" indices which use alternative approaches to market capitalization to weight stocks. It confirms that heuristic, optimized and fundamental-weighted indices give better risk-adjusted returns than the market capitalization-weighted index.
The study has implications for funds where the portfolio is designed to mirror a market index.
More about market capitalizationweighted indices, monkey portfolio, Cass Business School
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