The Investment Circus: Why Mean-Ignorant Monkeys Beat Median-Jumping Clowns

by: Nick Gogerty

Occasionally a bored business publication goes to the zoo, rents a monkey and pits him or her against a mutual fund manager. Lo and behold the monkey who doesn't know a beta from a bunghole beats a significant majority of the active managers. Barron's should probably create a yearly Monkey Roundtable. These journalists must be pretty good monkey pickers and should probably start a MFoF (Monkey Fund of Funds) charging 2% and 20%. We are the Third Chimpanzee and it seems as if evolution must have robbed us of our stock picking skills, but boy can we pick monkeys.

So what is going on? Charlie Munger and Warren Buffett both hint at it in various writings and books; my favorite is Charlie's Poor Charlie's Almanack. Warren calls it de-worsification, or the fact that many portfolios get worse as more components are added to them. The theory which he pretty well proves via his actions is that the more holdings you have, the less likely you are to know a lot about any of them. He doesn't say it, but most managers also jump the median, the investment equivalent of jumping the shark. Buffett and Munger both hint at investing being similar to parimutuel betting.

The reason mean monkeys beat median jumping clowns is that most fund managers really don't understand the sustainable economic value drivers behind the businesses they invest in, and therefore can't allocate well at the individual equity level.

Mean Monkeys picked by journalists have one of the key behavioral principles in investing; ignorance. They don't know or even pretend to know anything.

Stock returns as exhibited on page 73 of Mebane Faber's great new book, The Ivy Portfolio, shows the problem. Stock returns are log normally distributed having fat tails.Lifetime returns for equities Cumulative distribution of equities over time
The charts are sourced from Blackstar funds and reflect data from 1983-2007.

The Mean Ignorant Monkeys

When I tell my wife that ignorance and apathy are key investment traits, she just rolls her eyes. Put another way, know what you don't know and be patient, as activity kills in this game. Ignorant Mean Monkeys beat funds because they allocate naively, i.e. equally in their portfolios. God forbid the monkeys start running mean variance optimizers or the game is over. Mean variance portfolio allocation is probably one of the most costly rearview mirrors of all time.

Suppose that out of the universe of 8,000 equities above, Mr. Mean Monkey takes on Mr. or Ms. Median jumping manager by throwing his darts. Most of these competitions stop right there. Rarely do the journalists ask the monkey about next quarter's earnings projections or where the Dow will be next week. The monkey's bets are spread equally across the selected equities and the race with the clowns is on. The clowns' performance is usually measured by their fund's returns.

The monkeys should perform roughly the same as a naive (unweighted) index with a small cap bias. Why? The monkeys are simply taking a random sample of the markets, so the returns should be roughly equivalent to the chart above. The smaller cap bias will reflect the greater number of smaller cap firms present in any sampled universe of investable firms.

Imagine that from the 8,000 stocks, the monkey selects 8. One could think of the chart above broken into 8 bins. That is what the monkey's return will equate to. The monkey is an approximate unbiased sample of the market.

Send in the Median Jumping Clowns

The active fund manager "median jumper" clown does the same thing with his or her 8 picks, ideas, gambles, allocations or whatever glossy euphemism he or she uses in their marketing literature. But the clown is at a disadvantage because they don't know what they don't know, so they decide to weight the portfolio according to the "best" picks. Uh oh, here is where the trouble starts; they just jumped the median and probably picked something closer to the mode, the most commonly occurring sample.

The Median is not the Mean

The statistical mean is what most people consider the average of returns. More important is the median and mode, the most likely sample to be chosen, and the number separating the higher and lower half of the sample. It works like this: You and 7 of your friends find yourselves in a room playing bridge with Bill Gates and Warren Buffett. The mean (average) net worth of the individuals in the room is measured in the billions, but you don't feel any richer, because most likely you are one of the 8 representing the mode, or most common sample in the room, which is below the median and the mean.

The median and mode for shares' returns is actually well below the cap weighted index which is closer to the mean. The charts above indicate 64% of shares underperform the index. This means that managers who "tilt" or weight their portfolio to their best idea are statistically taking a random sample and doing bad things, increasing the odds of picking a sub-index performer, and in so doing also diminishing the allocations to the potentially significantly positive outliers that help deliver the mean performance.

This is classic behavior flaw 101; people with more information believe they know more about something. So the fund manager takes the useless sell side research reports, technical analysis and other hocus pocus that they haven't back tested or thought through, and parks a few more chips on red.

Few managers really understand businesses. Not many money managers have actually run a competitive business and understand the dynamics of a "market for goods and services". When it comes to fund management and equity selection, I will bet on a humble person who has run a successful small business over somebody who can tell me what they think the Fed is doing.

Stock "business" selection skills are different from macro economic analysis and best learned by doing. People straight from school and fed into the investment banking world are put into an environment that demands answers even when there aren't any. Smart people who don't have answers or admit ignorance get weeded out. This is an environment rarely interested in posing interesting new questions, which is a far more interesting and important skill requiring imagination. Even Buffett ran a gas station into the ground and probably learned as much from it as from his Columbia MBA.

Transaction and operational costs etc. also injure manager returns. This is the case of apathy / patience proving things out. Fund managers are like trapped animals. They get caught, then get nervous and waste energy trading and allocating instead of sitting quietly and thinking about what the dynamics of the game they play truly are. My suggestion: shut off the screen and Blackberry and go fishing etc. for awhile and reflect. Maybe a few answers will pop into your head, if you are truly lucky a profound question will arise.

The well known reality is that most fund managers underperform a passive representative index. Managers don't know what they don't know. They are often in the giving answers business as they rise from analysts to portfolio managers; some are just great salesman stock brokers. Cramer is the worst public example of an analyst gone wild. He is a bottomless pit of useless answers filling the airwaves to pimp cars, cereal and pills for CNBC. Felix Salmon has his own equivalent answer hole in Ben Stein.

An answer hole (my term) is a bottomless pit where questions are thrown in and answers are always on offer. The only thing not found in the answer hole is an honest phrase such as "I don't know."

Most Mutual Fund Managers could significantly increase their long term performance with an equivalent naive asset allocation across the board and less activity, assuming they have a random sample. They could at least aspire to mean monkey performance and still get the fun of throwing darts, while causing less harm.

$6.24 Trillion Dollars of Clown Self-Delusion

For fun, take a look at your fund's top few holdings ideally representing 80% of the portfolio, and allocate them equally. You might find that a Mean Monkey portfolio approach beat your manager's median jumping.

Calling mutual fund managers clowns may be rough, but if a $26 trillion industry underperforms the naive approach by 1.0% and the average fund has expenses of 1.4%, that means you or your pension fund loses $26 trillion x 2.4%= $624 billion a year playing the fund game. The label 'clown' doesn't seem too harsh and is more fun and lighthearted than the anger going around these days. Over 10 years that lost clown value would equate to $6.24 trillion, not including opportunity costs and compounding. Send in the monkeys! Figures like that sound almost stimulating don't they? (groan inducing macro pun intended)

Hedgies lost 18% on average in 2008, which beat most indexes by 20% and blew away most mutual fund managers. Please note the even with the Madoffs etc., in aggregate the Hedgies who have light regulation outperformed the highly regulated mutual fund industry scam. If I wrote the pension laws. I would limit the allocations to active mutual fund managers significantly.

I have a crude outline for a book called Circus Economics & Investing. It is all about how economics and investing works. It will have stories about monkeys, clowns, three-ring circuses, yield totters, horse races, magic tax tricks and leveraged tightropes, describing how life works under the lights in the big tent we call capitalism. I have also developed some nice "naive" parameterless algorithms for swap spreads, rates, volatility etc. with +3.0 sharpe ratios, if there are any interested hedgies out there.

If you have a large equity portfolio, I offer a portfolio risk elimination service which makes a recommendation on which of your top 10 holdings to eliminate, in order to boost returns.

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