Why dart-throwing monkeys can be dangerous and dirty
Kiwi Wealth’s fund managers have challenged the prevailing view that passive managers do better than active managers in the long run. Bernard Hickey reports on the debate, starting with the old story about monkeys with darts outperforming fund managers.
It’s an apocryphal story that is so appealing that most investors still believe it. But like most apocryphal stories, it’s just plain wrong, and in this case, in a surprisingly counter-intuitive way.
Back in 1973, Princeton professor Burton Malkiel wrote in his often-reprinted best-seller, A Random Walk Down Wall Street, 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.”
Ever since then, and increasingly in the last 20 years, investors have been fed studies purporting to show that most stock pickers do worse than the underlying market over the long run, and charge much higher fees than index-trackers. ‘Why pay for fund managers when a monkey could do better for free?’ has been a common refrain. Standard and Poor’s, the indexing firm, has even produced a website called SPIVA (S&P Indices Vs Active) that says that 76 percent of large capitalization US funds have underperformed the US S&P 500 index over the last five years.
The idea that random selections from a list of stocks would do better than highly-paid humans is now embedded in the minds of most regular stock investors. They are now hyper-focused on reducing the pain of fees when nominal returns are lower than in the 1970s and 1980s because of very low inflation and interest rates. Everyone apparently ‘knows’ that monkeys or ‘robots’ tracking indices do better than human fund managers. The trouble is they’re wrong about the monkeys being the same as index trackers, and they’re wrong about passive funds always doing better than active funds. More on that later.
The ‘monkeys’ are in front
Firstly, the weight of recent history seems firmly with the monkey-lovers. Many individual ‘retail’ investors have turned to index-tracking ‘passive’ funds. They have grown spectacularly in the decade since the Global Financial Crisis as investors opted for index trackers with low fees that are designed to be easily bought and sold as an Exchange Traded Fund or ETF, often through a broker, stock exchange or online platform.
Index-tracking pioneer Vanguard and the global funds management behemoth BlackRock, which owns iShares, manage over US$13 trillion between them, a substantial proportion being managed passively. Passive funds and closet index-tracking fund managers and sovereign wealth funds now own over half the world’s shares and over a quarter of the world’s bonds.
Investors think they’ve found their very cheap monkeys to do the work, but they haven’t because index-trackers simply choose the biggest and most valuable stocks on the market whenever the index is re-set. That’s not the same as a random selection.
“No-one actually went and hired a bunch of monkeys on the back of Malkiel’s work,” says Kiwi Invest’s Head of Quantitative Strategy and Responsible Investment Steffan Berridge. Kiwi Invest is Kiwi Wealth’s wholesale fund manager.
“What people tended to do was go and see passive investing as the way of investing according to monkeys,” he says.
Berridge decided to try to find out if the story about the room full of monkeys, the flurry of darts and the financial pages was actually true. Essentially, he was challenging the primacy of the idea that passive was always best, and asking the question: are those apparently cheap and cheerful index-trackers actually outperforming humans selecting stocks?
The answer he found was no, and the reasons why were just as surprising, and help explain why index-huggers often do worse than stock pickers. It also shows why a one size all method doesn’t always work out best for everyone. Kiwi Invest published this paper with the results of the investigation by Berridge and the Kiwi Invest team. It was commented on by Otago University's David Lont in this Newsroom article last month.
Monkeys actually beat index trackers
It turns out the monkeys making random choices actually do better than both passive funds and a stock index weighted by market capitalisation (an index dominated by the most valuable stocks such as the S&P 500). It makes sense when you realise that smaller and cheaper companies usually perform better than the biggest and most valuable stocks over the long run, in part because their performance often reverts to the mean. So when relatively cheaper and smaller stocks are picked, they almost always do better.
The ‘monkey’ just happened to ‘pick’ more of these stocks because there are many more smaller stocks in the overall US stock market than in the S&P 500 index, which is dominated by the biggest companies such as Facebook, Apple, Amazon, Netflix and Google.
Berridge points out that back in 2013, fund managers from US-based Research Affiliates, which now manages US$185 billion in funds, conducted an experiment for this research paper titled ‘The surprising alpha from Malkiel’s monkeys and upside down strategies.’
They replicated the performance of two portfolios of US stocks from 1964 to 2012. One picked every stock on the market equally in an approximation of the monkey randomly picking stocks, and the other essentially tracked the market-capitalisation weighting of the market (ie it kept buying the most valuable shares the most).
“Monkeys are better than passive investing. And this paper goes through why. It goes back to how large and small companies perform over time,” he says.
“If you get enough monkeys you just kind of evenly distribute and get more small companies. So monkeys tend to have that small capitalisation bias and outperform historically.”
The long-term history of investing shows smaller market capitalisation companies outperform larger ones as they grow faster and ‘revert’ to an average higher value, and cheaper large companies, which are seen as ‘value’ stocks, also perform better.
But they are riskier because they’re more volatile, and they require work to understand and find. For some people, that risk will be too painful to stomach, while others feel better about it and have the longer savings horizon over which they handle volatility.
Truly active funds outperform
Berridge says that’s where the active managers come in, and is one of the reasons why truly active investors do better than both the trackers and just a random selection. Active managers have to work understand the risk appetite of the investors and to match that with the riskiness of the investment and get the best possible returns.
“So we ask what's happening inside the company. Is it managed and governed well as well as getting a good return on equity? Are its earnings growing and how it's impacted by the macro environment,” he says.
Active managers also look at how liquid an investment is, which means how easy it is to get out of or into a stock in a hurry at a decent price. Again, not something a monkey can do. The monkey’s darts are just as likely to hit illiquid small stocks as liquid big ones.
“If it's less liquid, that's going to create extra risk for your investors or maybe a mismatch between what your investors are expecting in terms of when they can get their money out, and what they're getting.”
Liquidity is important because tracker funds prioritise liquidity by putting most of the investors’ money in the biggest and most highly valued stocks. That’s great for ease of exit and entry, but maybe not for performance.
There’s also a big range of types of ‘active’ investors. Some are more like passive index-trackers than actual fund managers. Some even say they’re active, when they’re more like an index ‘hugger’.
Berridge points to a study done in 2009 developed by two Yale professors, Martijn Cremers and Antti Petajisto. It has been updated since then to take in results after the 2008 Global Financial Crisis.
“The most active stock pickers outperformed their benchmark indices even after fees, whereas closet indexers underperformed. These patterns held during the 2008–09 financial crisis and within market-cap styles,” Petajisto said in this 2013 paper.
The Cremers/Petajisto studies showed that the harder fund managers worked to be different to their benchmark, the better they tended to perform. That all means there's a sweet spot where performance and fees are the best combination, as Kiwi Invest describes in this chart.
A self-interested and tautological measurement
So, unlike the SPIVA suggestion that all stock pickers were the same and most underperformed US stocks, a more detailed measure showed true stock pickers did better.
Berridge also challenges the way SPIVA does its comparison, and some of the biases in recent history towards the large capitalization stocks that index funds prefer. He says SPIVA does the choosing of which benchmark the active manager is performing against, when the manager themselves may be focused on doing better than another benchmark more appropriate to the investors’ risk appetites. So what might be underperformance against a risky benchmark, may be outperformance over a less risky benchmark. The S&P selection of the benchmark based on what’s in the active fund means they are often compared to assets they’re already invested in, which gives the comparison a tautological flavour.
There’s also the large company bias and US focus of the SPIVA measures. Most fund managers agree the US market is hard to outperform because it is so liquid, and the biggest companies such as Facebook, Apple, Amazon, Netflix and Google (FAANGs) have done very well in the last five years, when the long sweep of history would suggest they don’t.
Then there’s SPIVA’s authors (S&P Dow Jones Indices) themselves, who make money by creating and selling indices information to…index trackers.
“There's only one research agency that's claiming this very loudly all the time and it's S&P. That’s their business model,” Berridge says.
He points to studies by another firm, AQR, which measures the performance of active managers against the MSCI World index, which is produced by a competitor to S&P.
“They reckon the average outperformance for retail funds was 31 basis points by active managers. That's an opposite result (to SPIVA),” he says.
Performance for institutions was even better.
“Let's say someone like us or someone even better like ACC, who have interviewed a bunch of managers and selected them as a professional intermediary or investment manager. They (AQR) found those type of accounts outperformed by over a percent (100 basis points), which is an extremely good result over 20 years.”
Tax and Sustainable Investment
Berridge also points out the poor performance of tracker funds on sustainable investment and adjusting for tax in various jurisdictions.
“If companies are treating the environment badly, treating people badly and not obeying the law and are not well run, eventually they're going to run into trouble,” says Berridge.
"The big index tracking firms simply opt for the biggest companies, regardless of whether they invest in coal or weapons, and regardless of how they treat their staff or pay tax," he says.
The biggest firms have performed better in recent years, but history suggest that will turn and it's worth asking if they will continue to hold their social license.
"I guess you've got to work out where democracy is going to come down on this, because as you know, bigger companies being the drivers is generally not going to drive better social outcomes. It's been smaller operators that have generally driven local growth. So I’m not sure if this is democratically sustainable," Berridge says.
“The vast majority of investors care at least a certain amount about Responsible Investing.
“And Vanguard and BlackRock are the weakest active owners that I have ever seen. If you look at the proxy voting record, which is all freely available on the SEC site, if you care to trawl through it, you will see they support virtually no shareholder proposals and vote with management on everything just about all the time,” he says
“They’re proving to be real wet fish and they are not voting for change on really important issues. It really upsets me because when I look at the discussion around our Responsible Investing here, we do have exclusion policies, but we also actually think the way to really drive change is to be an active owner.
“That means you're voting and talking to your companies and telling them what you expect.”
“Whereas, if you go through one of these ETFs, Vanguard and BlackRock, they are doing virtually nothing to support important environmental and social issues in their voting. They are focused on short term financial returns and apparently don't have much time for supporting better environmental and social outcomes, no matter what you hear the CEOs saying. They are not walking the talk at all.”
Berridge gave the example of a recent vote at a BHP annual meeting where Kiwi Invest voted to force BHP to withdraw from a coal lobby group. Vanguard and Black Rock voted with the management to stay in the lobby group.
Tracker funds also often fail to take advantage of specific tax credits in various markets, particularly when investing through global funds, he says. Global tracker funds based in Australia, for example, were not passing through tax credits to investors, effectively making their costs higher than they first appeared compared with NZ-based PIEs.
* Kiwi Wealth is a foundation supporter of Newsroom.
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