Why indexing isn’t monkey business

In his classic 1973 book, A Random Walk Down Wall Street, economist Burton Malkiel joked that blindfolded monkeys throwing darts at stock tables could build portfolios as well as highly paid analysts. The first index mutual fund appeared two years later and has since outperformed the vast majority of professional money managers, just as Malkiel predicted. But now those monkeys have turned their darts at indexers.

This spring, the Cass Business School of City University London published two research papers comparing traditional indexing to 13 alternatives. The results were jaw-dropping. Every one of the alternative strategies produced better backtested results in U.S. markets between 1968 and 2011. Over this period traditional indexing delivered an annualized return of 9.4%, while the others came in between 9.8% and 11.5%.

It gets worse. The papers presented a simulation involving randomly generated portfolios of 1,000 stocks each. “Effectively we programmed the computer to simulate the stock-picking abilities of 10 million monkeys,” the authors wrote. Guess what? “Nearly every monkey beats the performance of the market-cap [traditional] index.” Ouch.

So, is it time for Couch Potatoes to switch to bananas? For two reasons I’d answer no: one theoretical, one practical.

It’s about small-cap and value stocks. The first point is why plain-vanilla indexes underperformed. Traditional stock indexes are based on market capitalization, or “market cap” for short. A company’s market cap is its current share price multiplied by the number of outstanding shares. Royal Bank has 1.45 billion outstanding shares, so if it’s trading at $62 you multiply those two numbers and get the bank’s market cap: $90 billion. That makes Royal Bank the largest company in Canada and the top holding (about 6%) in the widely followed S&P/TSX Composite Index.

By their nature, cap-weighted indexes give the most influence to the largest companies. Smaller companies, plus any that happen to be undervalued, get a much smaller share. That’s a potential problem because small-cap and value stocks (those considered cheap based on fundamentals) tend to perform best. Since 1927, small-cap and value stocks in the U.S. outperformed the broad market by about 2% annually.

All of the alternative strategies in the Cass papers gave more influence to small-cap and value stocks. Consider an equal-weighted index that assigns every firm the same influence: that methodology has smaller companies punching well above their weight. (The monkeys’ random portfolios were all equally weighted.) Other alternative indexes were fundamental-weighted, so they give more influence to firms with value characteristics like high book-to-market ratios or high dividend yields. These greater allocations to small-cap and value stocks are why the alternative indexes outperformed.

Why not use one of the alternatives? That leads to a more practical question, considering that MoneySense has recommended cap-weighted index funds in our Couch Potato portfolios for over a decade. Shouldn’t we embrace the alternatives?

We have, in a way. In The MoneySense Guide to the Perfect Portfolio, I suggest a “tilt” to small-cap and value for sophisticated investors with large portfolios. But I stop short of recommending that for everyone.

One reason is cost. Cap-weighted indexes may be flawed but they sport ultra-low fees (some under 0.10%), with minimal trading costs and supreme tax efficiency. Meanwhile, ETFs using alternative strategies have higher fees (typically 0.50% to 0.70% in Canada), and tend to do more trading and distribute more capital gains. These extra costs can easily eclipse theoretical outperformance.

A second reason is behavioural. Alternatives look enticing today because market-cap indexes performed poorly in the 2000s, a decade that included two devastating bear markets. But they were the top performers in the 1990s and also did very well in the 1980s. Every alternative strategy is bound to spend time in the doghouse at some point, and investors can easily fall into a pattern of chasing whatever’s done well recently, which always ends badly.

Here’s another way to think about it. Is there an investor anywhere who can honestly say the reason his retirement nest egg fell short was because he used cap-weighted index funds? No way. Are there investors who failed because they constantly moved from one strategy to another as they tried to beat the market? Absolutely—that’s the classic recipe for blowing up portfolios.

Cap-weighting may not be optimal, and if you’re truly committed to an alternative indexing strategy, I won’t try to talk you out of it—as long as every other piece of your financial plan is in place. But if you’re not saving regularly or haven’t got a track record of disciplined investing, you need to plug those holes before worrying about squeezing a little extra return from your portfolio.

For more index investing ideas, visit Dan Bortolotti’s Canadian Couch Potato blog at MoneySense.ca