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Thank you for referencing the WSJ article by Brett Arends on “A Random Way to Get Rich”.
Although I subscribe to the Journal, I missed this article. I believe it provides important investment guidance for several reasons.
It emphasizes the significance of careful benchmark selection. If you don’t measure anything with precision, you are likely to reach a wrong conclusion or design.
Typically, especially with respect to MFO, benchmarks are discussed in terms of individual mutual fund holdings. It is inappropriate to contrast the performance of a Balanced fund against the S&P 500 Index.
Extending the benchmark concept to the next level, it is equally inappropriate to contrast the performance of a complex portfolio with many moving parts against the simple S&P 500 Index. Arends article addresses this particular issue, and he offers a flexible alternate benchmark yardstick. Good for him, and good for us.
In his piece, Arends said: “It is well-established that most active money managers destroy value compared with a traditional stock index. It is less well-known that the traditional stock indexes destroy value when compared with just picking stocks at random.”
The second part of that quote demonstrates the utility of portfolio diversification and the need for a meaningful construction of a benchmark measurement to better judge performance. Bad measurement precedes faulty actions.
In the article, Arends reports that in 99% of the random cases explored, the random selection approach outperformed even the Index. The fact that the analysis was repeatedly completed in a random manner strongly suggests that the calculations were made using a Monte Carlo-based tool. Good for them. That’s a perfect application for random, uncertain problems.
However, their findings must be interpreted with some skepticism and caution, especially since the details and the assumptions of the analysis procedure were not reported. For example, if the Blinded Monkey had all stocks as their targets (small and large), a comparison against the S&P 500 Index (large only) is not proper and is, consequently, defective.
As a sidebar, the Blinded Monkey is an overkill to illustrate the point. It is unlikely that a non-blinded monkey would do any better at dart throwing than his blinded compadre. Investment outcomes are a combination of luck, skill, and timeframe.
I found the article both delightful and informative. Too bad that the MFO readership numbers are so low.
A random selection of S+P 500 stocks will probably result in a collection of stocks with on average lower capitalization. Isn't that an explanation for the outperformance. The equal weight ETF outperformed by about 2% over the last ten years.
Since each has been formulated with its own disparate weighting functions, I think of the Equal and Cap weighted S&P 500 Indices as entirely different animals. They are likely to react differently under special market circumstances. Some professionals believe that the Cap weighted variety will outperform in a more or less constantly rising Bull market.
Certainly you are correct that the Equal weighted version has historically outperformed for its entire history. But the relative performances have been marked with a bumpy ride; each has been a leader for brief time periods.
Regardless of the weighting, the S&P 500 is still a limited target of only 504 large firms at this moment.
Historically, the Fama-French academic work has concluded that small cap outfits offer a higher return over their larger rivals.
I suspect that the Blinded Monkey will still randomly toss a portfolio that outdistances either S&P 500 Index given an expanded small company and large company target field. The relative outperformance will be dependent on the Index yardstick selected, and will also be timeframe dependent.
I am not familiar with any study that specifically addressed your suggestion. So, at best my outcome suspicion is an educated estimate, and at worst it is a pure guesstimate.
@jerry: Rob Arnott of Research Associates [Research Associates was referenced in the linked article] supports what you are saying to some extent. He has done a lot of research in this area, and he concludes that almost any way to construct an index has outperformed a capitalization weighted index. Part of it is what you said, the fact that you get an average lower cap of the stocks. Rob Arnott says that a big part of it is that a cap weighting overweights the most expensive stocks, the most overvalued ones [cap weighting=price X shares outstanding]. He also says that market cap weighting does not capture the economic footprint of a company. For example, although Apple is weighted the most heavily in a cap weighted index, iirc, Walmart has the most sales of any company in the U.S., which relates more to economic footprint. So he believes in weighting on more fundamental factors, such as [again, iirc] cash flow, dividends, etc, to weight by economic footprint rather than by market cap.
For Rob Arnott, the key thing is to NOT weight the portfolio by price, which is essentially what a market cap weighting is doing, as price x #shares. He says that by market weighting, you are pushing away value, and loading up on growth......favoring stocks that have higher valuations.
Here's an interview [with transcript if you prefer that] that adds to the discussion above:
By the way, I don't own any of the fundamental index funds. My index funds are the standard ones, which are cap weighted, mostly Vanguard. I haven't made up my mind wrt the best indexes to invest in, e.g., fundamental index methodology, different forms of factor weighting/"smart beta", etc. A while back I took a look at the performance of the Schwab Fundamental Weighted indexes, and I was not overwhelmed.....certainly not enough to want to sell my traditional index funds, pay the capital gains taxes, and purchase other index funds with a different weighting methodology.
What is being talked about a lot these days is weighting an index by size (smaller), value, profitability, and more recently, momentum. The DFA 'index' funds are now factoring these into their weighting methodology.
@mjg: from the trivia department......correct me if I am wrong, but the S&P 500 Index currently has 501 stocks. It's the Vanguard S&P 500 Index Fund that has 504 stocks, but that is different than the Standard & Poor's 500 Index. Note that the Schwab and Fidelity index fund versions also contain 501 stocks.
Standard & Poor's has a nice fact sheet on their index:
Finally, in the article which is the topic of this discussion, the author states that he is using a universe of the top 3000 stocks in the world, based on market value. So not the S&P 500.
Comments
Thank you for referencing the WSJ article by Brett Arends on “A Random Way to Get Rich”.
Although I subscribe to the Journal, I missed this article. I believe it provides important investment guidance for several reasons.
It emphasizes the significance of careful benchmark selection. If you don’t measure anything with precision, you are likely to reach a wrong conclusion or design.
Typically, especially with respect to MFO, benchmarks are discussed in terms of individual mutual fund holdings. It is inappropriate to contrast the performance of a Balanced fund against the S&P 500 Index.
Extending the benchmark concept to the next level, it is equally inappropriate to contrast the performance of a complex portfolio with many moving parts against the simple S&P 500 Index. Arends article addresses this particular issue, and he offers a flexible alternate benchmark yardstick. Good for him, and good for us.
In his piece, Arends said: “It is well-established that most active money managers destroy value compared with a traditional stock index. It is less well-known that the traditional stock indexes destroy value when compared with just picking stocks at random.”
The second part of that quote demonstrates the utility of portfolio diversification and the need for a meaningful construction of a benchmark measurement to better judge performance. Bad measurement precedes faulty actions.
In the article, Arends reports that in 99% of the random cases explored, the random selection approach outperformed even the Index. The fact that the analysis was repeatedly completed in a random manner strongly suggests that the calculations were made using a Monte Carlo-based tool. Good for them. That’s a perfect application for random, uncertain problems.
However, their findings must be interpreted with some skepticism and caution, especially since the details and the assumptions of the analysis procedure were not reported. For example, if the Blinded Monkey had all stocks as their targets (small and large), a comparison against the S&P 500 Index (large only) is not proper and is, consequently, defective.
As a sidebar, the Blinded Monkey is an overkill to illustrate the point. It is unlikely that a non-blinded monkey would do any better at dart throwing than his blinded compadre. Investment outcomes are a combination of luck, skill, and timeframe.
I found the article both delightful and informative. Too bad that the MFO readership numbers are so low.
Best Wishes.
Thank you for joining the discussion.
Since each has been formulated with its own disparate weighting functions, I think of the Equal and Cap weighted S&P 500 Indices as entirely different animals. They are likely to react differently under special market circumstances. Some professionals believe that the Cap weighted variety will outperform in a more or less constantly rising Bull market.
Certainly you are correct that the Equal weighted version has historically outperformed for its entire history. But the relative performances have been marked with a bumpy ride; each has been a leader for brief time periods.
Regardless of the weighting, the S&P 500 is still a limited target of only 504 large firms at this moment.
Historically, the Fama-French academic work has concluded that small cap outfits offer a higher return over their larger rivals.
I suspect that the Blinded Monkey will still randomly toss a portfolio that outdistances either S&P 500 Index given an expanded small company and large company target field. The relative outperformance will be dependent on the Index yardstick selected, and will also be timeframe dependent.
I am not familiar with any study that specifically addressed your suggestion. So, at best my outcome suspicion is an educated estimate, and at worst it is a pure guesstimate.
Thanks again for your insightful participation.
Best Wishes.
For Rob Arnott, the key thing is to NOT weight the portfolio by price, which is essentially what a market cap weighting is doing, as price x #shares. He says that by market weighting, you are pushing away value, and loading up on growth......favoring stocks that have higher valuations.
Here's an interview [with transcript if you prefer that] that adds to the discussion above:
http://www.morningstar.com/cover/videocenter.aspx?id=613699
By the way, I don't own any of the fundamental index funds. My index funds are the standard ones, which are cap weighted, mostly Vanguard. I haven't made up my mind wrt the best indexes to invest in, e.g., fundamental index methodology, different forms of factor weighting/"smart beta", etc. A while back I took a look at the performance of the Schwab Fundamental Weighted indexes, and I was not overwhelmed.....certainly not enough to want to sell my traditional index funds, pay the capital gains taxes, and purchase other index funds with a different weighting methodology.
What is being talked about a lot these days is weighting an index by size (smaller), value, profitability, and more recently, momentum. The DFA 'index' funds are now factoring these into their weighting methodology.
@mjg: from the trivia department......correct me if I am wrong, but the S&P 500 Index currently has 501 stocks.
It's the Vanguard S&P 500 Index Fund that has 504 stocks, but that is different than the Standard & Poor's 500 Index. Note that the Schwab and Fidelity index fund versions also contain 501 stocks.
Standard & Poor's has a nice fact sheet on their index:
http://us.spindices.com/indices/equity/sp-500
Finally, in the article which is the topic of this discussion, the author states that he is using a universe of the top 3000 stocks in the world, based on market value. So not the S&P 500.