Gil Weinreich of Research Magazine has a nice article entitled, “Why a Monkey Managing Your ETF Portfolio Could Boost Returns.” Concerning Rob Arnott, keynote speaker for ThinkAdvisor’s recent virtual conference, Weinreich writes:
To Burton Malkiel’s famous claim that a blindfolded monkey throwing darts could select stocks as well as investment experts, Arnott boldly showed the monkey would actually outperform active fund managers and market-cap weighted index funds.
How does an untrained monkey add this kind of value? By breaking the link between weight and price that handicaps professionals who tend to buy the largest, most popular stocks whose prices exceed their value.
In other words, most listed stocks are small and neglected, precisely those whose risk and return characteristics are most apt to outperform over time. So the blindfolded monkey is bound to capture more of that risk and return than the trained professional operating under constraints such as the need to deploy large hordes of investor cash.
In summary, because a monkey throwing darts is more likely to hit unknown small cap stocks, the monkey, on average, will do better than the average money in the market which invests proportionally in large cap stocks. Put another way, by definition most of the money in the market is invested in where most of the money is invested, since that is what makes large cap stocks large. They have a large capitalization.
We call this bias (to invest in large cap U.S. stocks and U.S. bonds) “an asset class and a half.” The half an asset class is the large half of U.S. stocks. We believe it is better to invest in all six asset classes.
We also think it is better to craft your asset allocation amongst U.S. stocks to tilt small and value and follow the efficient frontier.
For those investors who do not understand the efficient frontier, we have written a series of articles understanding “The Efficient Frontier Of Investing.” It is required reading for every investor.
If you have an asset allocation which is not on the efficient frontier, you have a portfolio which could either have a better expected return or a lower expected volatility.
Many investments are not even on the efficient frontier, and your allocation to the them should be zero.
And if you don’t have an asset allocation your portfolio won’t experience the boost in returns that comes from a rebalancing bonus.