Wednesday, 23 October 2013

Banana Beta: Monkeys Generally Out-Perform the Market

So much for the smug superiority of index investors constantly boasting how active mutual funds fail to beat the market. Yes, that's right, new research is showing that randomly chosen stock portfolios, aka those picked by dart throwing monkeys, would have beaten a market-cap index. Andrew Clare, Nicholas Motson and Stephen Thomas of Cass University tell us so in a two-part study (part 1 and part 2) titled An evaluation of alternative equity indices.

The researchers test a bunch of alternative equity index strategies - equal weighting, diversity weighting, low volatility weighting, equal risk contribution, risk clustering, portfolio minimum variance weighting, maximum diversification weighting, risk efficient weighting in part 1 and fundamental weighting in part 2. For US stocks from 1968 to 2011, the alternative strategies all beat the market-cap index by a substantial amount - 2% per year in several cases - whether risk-adjusted or not. Only in the decade of the 1990s (at the end of which the Internet bubble had not yet burst) did market-cap do best. In the 2000s, market-cap was plain bad while the other index methods did ok.

The simulated army of ten million random-picking monkeys are not to be trifled with, however. As well as knocking the stuffing out of market-cap indexing (I propose we call this "banana beta" to differentiate it from plain ole beta and the new improved smart beta), the monkeys also beat, on average, several of the alternative indices!! Equal weighting barely beats the simians. Equal risk, low volatility, risk efficient and fundamental indexing beat almost all the monkeys convincingly. These, plus maximum diversification, produced risk-adjusted (Sharpe ratio) results much superior to monkeys.

A very interesting other result of the papers is that a very simple momentum following market timing rule would have improved performance tremendously by more or less halving the maximum drawdown of the equity portfolio. Who would have not wanted to avoid the 40% value reduction after the 2008 crisis and only seen a 20% drop? Using this rule, the Market-cap index catches up to the alternative indices. The rule even looks potentially practical for a retail investor, though it would take some conviction to go from 100% in equities to 100% in T-Bills, or vice versa, depending on the signal.

It is isn't possible to invest in ten million monkey portfolios. And judging by their relative performance, I am reassured that low volatility equity ( I own some of BMO's ZLB) and fundamental equity (and some Invesco Powershares PXC) are a reasonable bet. As these researchers also found, I need to remind myself that the alternative indices have not and won't always out-perform every year or over even multi-year periods.

Thanks to Peter Benedek's RetirementAction weekly roundup of news for the link to Larry Swedroe's post on the same study.

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