“A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts,” wrote economics professor Burton Malkiel in his 1973 book A Random Walk Down Wall Street.
“Our results are not supportive of the monkey portfolio argument.”In the flurry of research papers and blog posts that have accompanied the rise of smart beta, some have leveled the same accusation at the investment world’s new kid on the block. Specifically, that any portfolio selected by Malkiel’s monkey would have the same value and small-cap biases that are found in factor-based strategies.
However, this is not the case, according to new research from the EDHEC Risk Institute, which appears in the latest Journal of Index Investing issue.
“Our results are not supportive of the monkey portfolio argument,” authors Noël Amenc, Felix Goltz, and Ashish Lodh wrote succinctly in their paper, “Smart Beta Is Not Monkey Business.”
“For a better understanding of smart beta strategies, it is crucial to analyze their construction principles, performance characteristics, and risk factor exposures,” they wrote, “including not only value and small-cap factors but also a variety of other well-documented risk factors, such as momentum, profitability, investment, low risk, and possibly others.”
The trio analyzed equal-weighted portfolios as well as factor indexes, testing for correlations between them and their benchmarks. They also inverted each portfolio to test the strength of the factor tilt in each case.
“It is important to not overgeneralize results that have been derived from testing particular strategies.”“Our results show that, although some strategies such as fundamental equity indexation may perhaps be mostly driven by a value tilt and may generate similar performance to their upside-down counterpart, many smart beta strategies display exposure to additional factors, as well as pronounced differences in factor exposures across different strategies,” Amenc, Goltz, and Lodh wrote.
The inverted portfolios generated lower returns, they found.
Several commentators have claimed that risk factor proponents were guilty of data mining to support their strategies. Last summer, AQR Founder Cliff Asness took them to task, producing data to support the long-term efficacy of factor investing and claiming the “cynics” had been “completely defeated on the field of financial battle.”
Although proponents of the “monkey portfolio” arguments may have a point with some strategies, the authors wrote, it was important to “not overgeneralize results that have been derived from testing particular strategies.”
“Although the monkey portfolio arguments may apply to particular strategies, they have been invalidated for the explicit factor strategies we chose as our main test portfolios here, and therefore these claims cannot be applied to smart beta strategies in general,” they concluded.
Take that, monkeys.
Related: Asness to Haters: Fama-French Weren’t Wrong. You Are. & The Backtesting Crisis