Before giving fund managers credit for good work, check how much of it could have been done by a monkey.
Monkeys can surprise you. This photo of a crested black macaque is a selfie. Aside from photography, monkeys are reputed to be surprisingly good at picking stocks. In his now-classic 1973 book A Random Walk Down Wall Street, Princeton University professor Burton Malkiel wrote that “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.” In recent years, research showed that monkeys (or, more precisely, randomly-generated stock portfolios) significantly outperform the stock market over the long run.
Monkey portfolios generally outperform the market
What may seem to be monkeys’ great handicap – their utter lack of interest in publicly traded companies – turns out to work to their advantage when it comes to portfolio formation. The stock market index represents companies in proportion to their size and is therefore dominated by large and fast-growing firms. By contrast, randomly selecting stocks into a portfolio tends to allocate more money to smaller and less glamorous companies, as well as breaking the link between portfolio weight and recent performance. Over extended periods, this blindness to company characteristics is rewarded with better investment returns. (While the reasons for this are subject to debate, overvaluation of in-vogue stocks seems to be one plausible explanation.)
Active managers exploit the “Monkey Effect”
If being oblivious to what’s going on in the market is what it takes to beat it, then you may not need a professional stock picker to manage your money. Or at the very least, you shouldn’t give investment managers credit for “the monkey effect” in their performance. This is the basic premise of our recent research paper.
Our approach is simple. On average, the performance of randomly chosen portfolios over the market index is similar to that of a portfolio where all stocks are weighted equally. We therefore study the correlation between the performance of active fund managers’ investment portfolios and the spread between equal-weighted and market-weighted portfolios’ performance. This can tell us how much of a fund’s performance could be replicated by mechanically tilting its portfolio toward an equal-weighted one. Of course, we also control for a range of other factors that have been known to impact investment returns.
Our results are striking. The equal-weight tilt is common among more than one thousand US mutual funds seeking to beat the S&P500 market index, and its extent is a key factor in explaining fund performance. On average, the size of the tilt is equivalent to investing 20 to 30% of a fund in an equal-weighted portfolio. Recognizing this fact in performance evaluation lowers the average fund’s risk-adjusted performance by as much as 0.7% percent per year.
Isolating the “Monkey Effect” in manager performance
Why might actively managed portfolios have a tilt toward equal weights? There are two possible explanations. One is that fund managers do this intentionally as they are aware that portfolios with random or equal weights generally outperform the market. Another is that this tilt is an unintended byproduct of their investment process (for example, the hit-and-miss nature of stock analysts’ recommendations could be analogous to throwing darts). Regardless of the underlying cause, an investor can acquire an equal-weight tilt much more cheaply than delegating the task to an expensive active manager – it is enough to combine a passively managed index fund (which can have fees of as little as 0.02% per year) with an equally-weighted one (with fees of as little as 0.2% per year).
After a series of legal and public-opinion battles, the credit for the monkey selfie was deemed to belong to the photographer; he did, after all, go to the trouble of travelling to the jungle, befriending the monkey, and setting up the camera – all necessary steps for us to enjoy the surprising photo. But when you come across surprisingly good performance by active fund managers, think twice whether they should get the credit (and the fees). Hint: they shouldn’t if a monkey could do it.
The authors evaluated the investment performance of actively managed U.S. mutual funds benchmarked against the S&P500 market index over the 1980-2009 period. They focused on the performance evaluation impact of including the spread between equal-weighted and market-value-weighted portfolios’ returns alongside established factors commonly used to assess fund performance. The article, titled “The equal-weight tilt in managed portfolios”, was published in Economics Letters in June 2019.