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.

Friday 18 October 2013

Another Way to Invest in ETFs - Buy BlackRock Shares

Believe in ETFs? Want to bet on their continued growth at the expense of mutual funds? Then buy shares in the world's largest provider of ETFs BlackRock (BLK). Today's announcement of a 14% growth in Q3 net income, "... driven mostly by the asset growth of its ETF business..." is rather impressive given the enormous size of the company. Of course, the potential danger is that managers / employees may take most of the ETF-generated profit growth at the expense of shareholders. Or that competition may reduce profitability. But so far that seems not to be the case. BLK's 5-year return is 132% while one of BlackRock's flagship ETFs, the S&P 500's IVV is up 106% and another, the Canadian S&P / TSX 60 XIU is up a mere 51%.

Monday 7 October 2013

Conference Board Shows Us the Mutual Fund Footprint

The Conference Board of Canada's Making Dollars and Sense of Canada's Mutual Fund Industry tells us that the industry is gigantic. How ironic and perverse. According to the definition of value added on page 2, the more the industry charges over its cost, the more it adds value. Bring on 10% MERs, that would make the industry even more valuable! The more inefficient it is, the better? There is a big missing piece. There needs to be consideration of the cost and value to consumers.This key issue is raised in this quote, "Fund management creates value in the economy through portfolio management activities, distribution channel creates value through the advice a fund dealer provides when selling a mutual fund to an investor". But then the report avoids assessing that critical aspect. Portfolio management that doesn't beat the index - that's value added? Advice from too many fund dealers that consists mainly of selling effort - that's value added?

In the terminology of the report, the industry has a huge economic footprint. Unfortunately the footprint falls heavily on the back of Canadians trying to save for retirement.
(Thanks to Ken Kivenko for the link to the report)

Wednesday 2 October 2013

Canadian DB Pension Plans Faring Much Better but DC Plans Only a Little Better

This article at Pension and Investments says rising stock markets and interest rates have really helped Defined Benefit Pension plans in Canada return much closer to long term viability lately, but another article laments the marginal improvement in the situation of Defined Contribution savings plans. However, there is a telling note that fully inflation-indexed plans, the kind people really need, aren't much better off since new actuarial rules are making them recognize their huge liabilities (Keith Ambachtsheer's fine book Pension Revolution - reviewed here - shows the significance of inflation indexing).

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