Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Study solves investment’s monkey puzzle
by David Chaplin
Even a blind monkey-based manager could outperform the average active fund by simply flinging darts at the stock index chart, according to US academic, Burton Malkiel, 88. His claim, first aired in his classic ‘A Random Walk Down Wall St’, has been used as anti-active ammunition ever since.
Later studies actually concluded a troupe of blindfolded simian dart-throwers would, indeed, outperform the index. But a new analysis by global index provider FTSE Russell suggests the observed ape alpha is a trick of the light, rather than down to the sharp eye and perfectly weighted throwing arm of Malkiel’s mythical monkey. According to the FTSE Russell ‘Inverting Factor Strategies’ report, the outperforming investment monkeys are typically measured against cap-weighted benchmarks while their random stock selections are assembled as equal-weighted portfolios.
“The key, here, is that, while the monkey selects the stocks, it does not choose the weighting scheme,” the study says. “The seemingly innocent decision that we should equal weight the stocks has profound implications.”
To test the theory, the report authors – headed by director of research and analytics, Sergiy Lesyk – created a monkey-like portfolio of 100 stocks randomly selected from the Russell 1000 each June over 1998 to 2021. The researchers then created two versions of the random portfolio, one weighted equally and the other according to market cap.
After repeating the process 100 times, the FTSE Russell results found “the equally-weighted monkey portfolio outperforms its capitalization-weighted counterpart”.
“However, neither of their performances deviates significantly from their respective Russell 1000 equal and capitalization weighted benchmark, indicating that our monkey does not possess any stock picking skill,” the study says.
“… The mystery of the outperformance of the monkey portfolio is simply a consequence of the active Size exposure of the equally-weighted monkey portfolio. This arises directly from the weighting scheme chosen, as opposed to any stock picking skill the monkey may have. Indeed, we could have chosen to weight the monkey portfolios by inverse stock volatility and then expressed ‘surprise’ that the monkey was producing portfolios with a low volatility orientation.”
Aside from debunking the money-making skills of monkeys, the FTSE Russell research also concludes that ‘smart beta’ strategies based on ‘simple weighting heuristics’ “do not permit precise control of factor exposures”.
“They, therefore, are unable to target specific intentional factor exposures or to create indexes which correspond to the inversion of a set of investment beliefs,” the report says.
However, the study says by using more precise approaches such as portfolio ’tilting’ “it is possible to readily construct factor strategies and their opposites in a transparent manner”.
FTSE Russell research and analytics executives, Peter Gunthorp and Andrew Dougan, also contributed to the report.
– Investment News NZ
