Active vs passive debate: the case of “monkeys”
As CalPERS considers switching all of its portfolios to passive investing, questioning the effectiveness of active equity investment, there have been some interesting findings that would stir up the active vs passive debate.
Researchers at Cass Business School find that equity indexes constructed randomly by “monkeys” would have produced higher risk-adjusted returns (ie return adjusted by measuring how much risk is involved in producing that return) than an equivalent market capitalisation-weighted index over the last 40 years.
How does this work? Using 43 years of U.S. equity data, researchers programmed a computer to randomly pick and weight each of the 1,000 stocks in the sample, effectively simulating the stock-picking abilities of a monkey.The process was repeated 10 million times over each of the 32 years of the study. Nearly all 10 million indices weighted by chance delivered vastly superior returns to the market cap approach. Andrew Clare, co-author of the paper, says:
“The results of this experiment showed that many of the monkey fund managers would have generated a superior performance than was produced by some of the alternative indexing techniques. However, perhaps most shockingly we found that nearly every one of the 10 million monkey fund managers beat the performance of the market cap-weighted index.”
But investment advisers are not fully convinced that active is the way. A survey by housing investment specialist Castle Trust shows one in three advisers do not believe they can beat the index over five years. Sean Oldfield, chief executive officer, Castle Trust says:
“Concern over the long-term ability of active managers to outperform their benchmark indices is well-documented and is recognised by advisers. They clearly recognise the need to deliver long-term performance for their clients and that should mean at least a core holding of index- tracking investments.”
The emergence of “smart beta” approach — kind of half way between active and passive investing — is prompting pension funds to reconsider equities. Read the analysis here.