Monkey Business

Man vs. Ape
The New York Times on Friday ran an article on how investors sabotage their long-term goals by making decisions based on short-term results. It carried a quote by Suzanne Duncan, global head of research at State Street’s Center for Applied Research: "Morningstar gives us false comfort," she said. "There's some truth to Morningstar's ratings. But there is untruth. Dart-throwing monkeys outperform market-cap-weighted indices."

All right, that passage requires some explaining.

That final sentence certainly does. If dart-tossing monkeys can reliably beat a stock market index, then monkeys would seem to have investment skill--and surely are worth the cost of zookeepers, cages, and bananas to employ as portfolio managers. The catch is in the adjective "market-cap-weighted." As Research Affiliates' Rob Arnott (presumably the original source of the quote) has argued, if small and value stocks outperform over time, as they have done historically, then any random stock-selection system would have a higher expected return than the S&P 500. This holds true regardless of the primate.

Thus, the monkey analogy does not support Duncan's previous sentences, which concern the usefulness of fund research. Rather, it argues that equal-weighted portfolios will outperform those that are cap-weighted. That is a topic worth discussing--but it is a different one from the nature of fund information.

As for the Morningstar star ratings (to which Duncan presumably referred), the statement that they contain both truth and untruth is superficially wrong. The star ratings are a straightforward math exercise that cannot be incorrect if the calculation program is properly written.

However, if we interpret "Morningstar's ratings" more broadly as "historical data" and "false comfort" as "believing that value exists where it does not," then her argument is very much on point. Investors place great importance on what funds did in the past--expenses, returns, risk, the fund company's reputation, and so forth. Is this faith misplaced? Should they have hired monkeys instead?

Happily, the question is easy enough to address.

We know from the "investor gap" that fund shareholders are poor at timing their purchases and sales. Those mistakes, however, have little to do with fund selection. They are instead decisions of asset allocation--selling weak-performing asset classes before they rebound and buying into hot (and expensive) asset classes near their peak.

We can isolate how investors fare at fund selection by returning to this column’s initial subject, equal-weighted versus asset-weighted.

Conventionally, the mutual fund industry's performance is equal-weighted. Morningstar.com tells me today that specialty health care has the highest returns of any fund category over the past three years, at 31.02% annually. That result was calculated by averaging the totals for each specialty health-care fund over that time period, counting the whales and minnows equally.

Asset weighting, on the other hand, goes where the money is; if a single whale outweighs all the minnows, then that whale’s numbers count for more than those of all the minnows combined. Thus, asset weighting indicates how investors have fared at fund selection. If funds’ asset-weighted gains are larger than their equal-weighted gains, the big funds have beaten the small, indicating that investors have selected wisely. If the figures are similar, investors did neither worse nor better. And if the equal-weighted performance is higher, then investors were dumber than monkeys. They would have been better off growing bananas than conducting fund research.

The asset-weighted figures for the past 12 months--

The story looks pretty good for investors. However, the numbers contain a lot of noise. To cite just one example, the asset-weighted totals for U.S. equity funds are substantially helped by the fact that large-company stocks have walloped their small-company competitors for the period. As most giant funds hold the shares of bigger companies, the trend has favored investors; consequently, they appear smarter than they actually have been.

Things settle considerably when looking at a full decade--

Once again, investors fare pretty well. For sure, these results should not be considered conclusive. All fund research is time-period dependent. Sample another decade and the pattern may look weaker or possibly disappear altogether. Nonetheless, at least for the past 10 years, humans have comfortably bested the monkeys.

Much of this success, of course, owes to costs. To an extent, larger funds naturally have lower expense ratios because of their additional scale. However, that effect is less than is commonly portrayed, as most fund companies defray some expenses for funds when they are very small and have relatively flat management fees that don’t much decline when funds are very large. The main reason that bigger funds are cheaper is that those funds were built to cost less from the beginning. Investors have been savvy enough to recognize the advantage that comes from holding such funds and have done so successfully.

Cost does not appear to be the entire story, though. With international-stock funds, balanced funds, alternative funds, and municipal-bond funds, the performance difference between asset-weighted and equal-weighted funds is larger than the expense difference between the two groups (roughly 50 basis points). Perhaps something else is going on? Perhaps investors have successfully identified other attributes that have made their selections better than random?

Perhaps. I do not know how to torture the data to confess that answer. But the figures do suggest that whatever decisions investors have made in addition to costs have been harmless at worst and beneficial at best. They have not wasted their time selecting funds on monkey business. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.