Next time I have some money to invest (not that I expect to be in that situation anytime soon), you might find me hanging around the monkey enclosure at London Zoo.
This comes after research published this week by Cass Business School and Aon Hewitt concluded that equity indices constructed randomly by ‘ monkeys’ would have produced higher risk- adjusted returns than an equivalent market cap-weighted index over the last 40 years.
Based on monthly US share data from 1968 to 2011, the study found nearly all 10 million indices weighted by chance delivered vastly superior returns to the market cap approach.
Cass professor Andrew Clare, co-author of the report, explained: “We programmed a computer to randomly pick and weight each of the 1,000 stocks in the sample; we effectively simulated the stock-picking abilities of a monkey. The process was repeated 10 million times over each of the 43 years of the study.”
He concluded: “One of the implications of our work is that we should perhaps be benchmarking our fund managers against monkeys rather than against a cap-weighted index.”
This discovery is likely to come as a blow to investors that have billions of dollars worldwide invested on a market cap-weighted basis and no doubt fuel the argument for a more customised approach to indices – or ‘smart beta’ as we know it.
The growth of smart beta has been inevitable as investors seek outperformance beyond market-cap and there has been an influx of products to meet the demand. But as a concept it is still in its infancy and there remains investor uncertainty around exactly what smart beta is and how to measure the risks and opportunities that come with it.
Investors need a point of reference but at the moment the market lacks a defined framework to compare these strategies. Initiatives such as EDHEC-Risk Institute’s ‘Scientific Beta’ – a smart beta platform geared up to help investors understand and invest in advanced beta equity strategies – will help, but a wider industry push/backing is needed.
Elsewhere, smart beta fees must be addressed as it seems some of the early movers are charging close to active management fees. For the market to really grow and for these products to become widely accepted they have to be a lot closer aligned to pure passive fees, otherwise ‘what is the point?’ investors will surely ask.
Chimpanzees are a human’s closest living relative – sharing 96% of our DNA – but I’m still not sure asset managers will be hiring monkeys for their investment teams just yet.
Cass’s study does however illustrate a flaw in cap-weighted indices and smart beta will no doubt develop as a strategy. But for now investors need to fully understand the opportunities and risks because ultimately they need cheap and transparent products.
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