“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.” So wrote Princeton economist Burton Malkiel, famously, in A Random Walk Down Wall Street (1973). The other week the Wall Street Journal ran an article by Jack Hough of Barron’s revisiting the subject of monkeys’ stock-picking prowess in light of two new reports, one from S&P Dow Jones Indices and another from London’s Cass Business School.
Hough begins by noting that actively-managed mutual funds tend to underperform their benchmarks.
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.
Hough’s point about mutual fund underperformance is well-taken, and indeed it’s part of the reason that here at O’Brien Greene we avoid investing in mutual funds. The closure rate of mutual funds — even the relatively high-ranked ones — is alarmingly high. (Click here and scroll down for some charts on this subject.) Furthermore, mutual funds are tax-inefficient for their long-term investors compared to investors who hold individual stocks and bonds through separately managed accounts. (Just this past weekend an article in Barron’s reported on a study that shows that the average separately managed account outperformed the average institutional-class mutual fund by 0.62 of a percentage point annually from July 2000 through December 2010.)
There is an argument to be made, however, that “beating the market” over the past five years isn’t something that a sensible stock investor should have been trying to do. Given how much of the market’s performance seems to be due to extraordinary and unpredictable government intervention — i.e., the quantitative easing programs directed by major central banks around the world that have inflated financial assets — it might be excessively risky to go in whole-hog on the present rally. If this is right, then the underperformance of fund managers relative to their benchmarks over the past five years wouldn’t necessarily be a bad thing. It might be prudence.
However this may be, let me consider Hough’s main point:
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.
At first glance this sounds remarkable. How could monkeys beat the market? Why can’t my professional manager do the same? Well, if your manager departed from the S&P 500 Index, which is biased towards bigger companies, by favoring smaller market-capitalization companies, then he also would have stood a better chance at beating the S&P 500. This is because the past two decades have been an extended period of remarkable outperformance by small and mid-cap companies, relative to their large-cap competitors. Dart-throwing monkeys, like randomly created indexes, aren’t biased towards bigger market-capitalization as the S&P 500 Index is. Therefore, a non-market-cap-weighted, equal-weighted index has tended to outperform the S&P 500 Index because small and mid-cap companies have tended to outperform.
As Hough notes,
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.
There’s no reason why going forward market leadership might not pivot back to large-cap companies. Indeed, we might already have begun to witness the pivot, since the S&P 500 Index is outperforming the Russell 2000 Index of smaller companies so far this year. In the 20th century, U.S. small-cap stocks have tended to outperform large-cap stocks. Even so, during that time there have been sustained periods of large-cap outperformance.
One very simple reason for thinking that a market-cap-weighted S&P 500 Index might be better than an equal-weight S&P 500 Index in the future is that trends tend to revert to the mean. The story about past equal-weight outperformance is increasingly well-known. Asset managers such as Guggenheim now offer a slew of popular equal-weight index funds. As more and more investors pile in to take advantage of past trends, the advantage will disappear, and the late-comers to the story will be left with middling performance at best.
Better to avoid the trend-chasing altogether and focus on identifying high-quality individual companies and owning them for the long-haul.