Apparently, monkeys can generate better performance than market capitalization-weighted indexes. At least that was the main finding of research done recently at London’s Cass Business School where it was found that equity indexes constructed randomly by a computer (or a pointing primate) produced higher risk-adjusted returns than an equivalent market capitalization-weighted index. And it isn’t just over the last year…or the last decade. It’s over the last 40 years—from 1968 to 2011.
The research is captured in this two-part paper: “An evaluation of alternative equity indices,”—Part 1: Heuristic and optimised weighting schemes and Part 2: Fundamental weighting schemes. The study is based on monthly U.S. share data and finds that nearly all of some 10 million indexes weighted by chance delivered far better returns than the market cap approach.
Now, the shortcomings of market cap-weighted indexes aren’t news for plan sponsors that have been grappling with the question for years. Taking a market cap approach, for example, means investors tend to be heavily tilted toward stocks that have experienced a run-up in price. In other words, overvalued stocks rule while undervalued stocks are weeded out.
The question is, What’s the alternative? In Canada, plan sponsors have been looking at them closely. Cass researchers, for example, found a few that were superior in performance to market cap. They explore the performance characteristics of U.S. equities indexes weighted different ways—total dividends paid by a company, total annual cash flow, book value, total annual sales, a combination of these alternative metrics of company scale.
In all cases, market cap came up short each and every time.
In the world of exchange-traded funds, the index is everything. And, on the retail side, a bit of underperformance is a small price to pay in exchange for much lower costs compared to active management. But for institutional investors, especially plan sponsors, the question of index will continue to loom large in the active/passive debate.
While some mull the use of new alternative indexes, others consider approaches like smart beta. But as researcher Nick Motson points out in this video interview, the beta might not, in fact, be all that smart—it only looks that way compared to the poor peformance of market cap-weighted indexes.
After all, when the bar is being set by monkeys, you don’t need to be all that smart to beat it.
This article first appeared on BenefitsCanada.com