The New York Times on Friday ran an article on how investors sabotage their long-term goals by making decisions based on short-term results. It carried a quote by Suzanne Duncan, global head of research at State Street’s Center for Applied Research: "Morningstar gives us false comfort," she said. "There's some truth to Morningstar's ratings. But there is untruth. Dart-throwing monkeys outperform market-cap-weighted indices."
All right, that passage requires some explaining.
That final sentence certainly does. If dart-tossing monkeys can
reliably beat a stock market index, then monkeys would seem to have
investment skill--and surely are worth the cost of zookeepers, cages,
and bananas to employ as portfolio managers. The catch is in the
adjective "market-cap-weighted." As Research Affiliates' Rob Arnott
(presumably the original source of the quote) has argued, if small and
value stocks outperform over time, as they have done historically, then
any random stock-selection system would have a higher expected return
than the S&P 500. This holds true regardless of the primate.
Thus, the monkey analogy does not support Duncan's previous sentences,
which concern the usefulness of fund research. Rather, it argues that
equal-weighted portfolios will outperform those that are cap-weighted.
Conventionally, the mutual fund industry's performance is
equal-weighted. Morningstar.com tells me today that specialty health
care has the highest returns of any fund category over the past three
years, at 31.02% annually. That result was calculated by averaging the
totals for each specialty health-care fund over that time period,
counting the whales and minnows equally.
Asset weighting, on the other hand, goes where the money is; if a
single whale outweighs all the minnows, then that whale’s numbers count
for more than those of all the minnows combined. Thus, asset weighting
indicates how investors have fared at fund selection. If funds’
asset-weighted gains are larger than their equal-weighted gains, the big
funds have beaten the small, indicating that investors have selected
wisely. If the figures are similar, investors did neither worse nor
better. And if the equal-weighted performance is higher, then investors
were dumber than monkeys. They would have been better off growing
bananas than conducting fund research.
The asset-weighted figures for the past 12 months--
The story looks pretty good for investors. However, the numbers contain a lot of noise.
Things settle considerably when looking at a full decade--
Once again, investors fare pretty well. For sure, these results
should not be considered conclusive. All fund research is time-period
dependent. Sample another decade and the pattern may look weaker or
possibly disappear altogether. Nonetheless, at least for the past 10
years, humans have comfortably bested the monkeys.
To check, I looked at RSP which is the equal-weighted S&P 500. For one year, it has returned 17.02% to the S&P 500's 16.86%. For ten years, it returned 9.37% to 8.06%. Monkeys win.