This is the fourth and final blog posted from Russell’s Institutional Summit conference that is currently taking place in Dana Point, California.
It fell to me to close this year’s institutional Summit, a task which involves wrapping up the previous two days’ of material and putting a nice bow on it. I also chose to address the subject of the smart beta monkeys, which many readers may have heard of. The monkeys in question can be found in recent work by Andrew Clare of Cass Business School, and these monkeys achieved exceptionally good investment results over a period going back more than forty years.
One school of thought has interpreted these results loosely as follows. “Ten million monkeys! And they just about all beat the market! Market cap must be a horrible way to represent the market! It’s just about the worst possible way to invest.” Which is not the right conclusion at all.
First, we need to note that the monkeys are—as a group—following an equal-weighed investment strategy. Few would describe equal-weighting as a brilliant or insightful approach to investing. So, given how difficult it is supposed to be to beat the market, it really is remarkable that this strategy has performed so well over a long period. But that doesn’t change the mathematics of markets. And the mathematics of markets dictates that, because investors in aggregate own the market, investors on average earn the market cap return. If the monkeys are beating the market average, then there’s another group of investors (I picture these as being lions or zebras) who are losing. For that reason, market cap remains the best representation of the market; that’s because market cap is the market. And it’s not the worst way to invest; it must be somewhere around average.
That’s not the end of the story, though. There is another conclusion to draw. For the equal-weighted strategy to have done so well for so long is more than just coincidence. There has been something systematic going on, which is the effect of factor exposures within the portfolio. That’s why this is a smart beta story. Smart beta is about the management of factor exposures.
In the example of the equal-weighted portfolio (and many other smart beta strategies) the primary relevant factors are small cap and value. Equal-weighting is, by construction, overweight to small cap relative to market cap. Similarly, it tends to buy losers and sell winners so is essentially a value strategy. It was a systematic overweight to these two factors that generated the results shown. The monkeys won over the period in question because small cap and value won. As Erik Ristuben and others described earlier at this event, smart beta is potentially much more than overweighting these two factors, but even that simple approach has been remarkably effective.
So the monkeys do tell us something important, but it’s not that market cap can be bettered as a way of representing a market, rather they tell us that factor exposures need to be consciously measured and managed.