Monkey See, Monkey Do?

Most market indexes are constructed using market-capitalization weighting, and in turn, many ETFs aim to track the performance of these market-capitalization indexes.

However, there are alternative methods of creating an index other than using market capitalization.  Some examples include equal-weighted, value-weighted, price-weighted, and fundamentally weighted indices.

This article cites a study that stock indices created by ‘monkeys’ performed better than market-capitalization indexes on a risk-adjusted basis from a period of 1968-2011.  This study showed randomly picking and weighting stocks (the monkey approach) outperformed the market-capitalization indexes!  In addition and of more practical use, the study also found that 13 alternative indexing strategies all performed better than the market-capitalization indexes.

These alternative indexing strategies, also known as ‘smart beta’, start to blur the boundaries between passive and active investing in my opinion.  However, they overcome some of the weaknesses inherent in market-capitalization indexes and can be a good addition to an existing portfolio.  As evidence in the above cited article suggests, they may also deliver better performance.

The study was conducted by the Cass Business School and the original research papers can be found here.

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