In a post titled Better Beta Is No Monkey Business that was published on The AllianceBernstein Blog on Investing, author Patrick Rudden took a different approach to looking at blindfolded monkeys throwing darts. The blindfolded monkey concept was popularized in Burton Malkiel’s book, A Random Walk Down Wall Street.
In his book, Malkiel suggests that a group of randomly selected, blindfolded monkeys could throw darts at a newspaper’s financial section and end up with a portfolio that outperforms a portfolio selected by a group of experts. Rudden builds his piece on previous research that suggests that the monkeys would be likely to outperform the experts because they would be biased towards selecting smaller cap stocks.
Rudden argues that:
Leaving monkeys (blindfolded or not) aside, the research conclusion is an important one. What it shows is the limitation of cap-weighted indices where the size of a constituent is a function of share price. Such indices by construction put more emphasis on stocks with high prices and less emphasis on stocks with low prices. They will favor components whose prices have risen the most.
He illustrates past examples of concentration risk:
This concentration risk is often unintended. And it creates risks that can be bad for your wealth when investors stampede out of crowded positions, causing violent market swings. As my colleague, Dave Barnard, points out in a recent paper,2 the technology sector ballooned to more than 29% of the S&P 500 in 2000 (Display). Over the next two years, the sector lost more than half its value. Similarly, Japanese stocks lost about a third of their value in the two years after their weight in the MSCI World Index peaked at 44% in late 1989. Similar trends played out in the energy sector in 1980 and in financials in 2007, at the peak of the credit bubble.
He continues by explaining that while cap-weighted index fund may have some benefits, there is likely more to be gained from a different approach:
But we believe that any approach which loosens the connection between weight and price is likely to have a performance edge. For example, investors could permit some increase in tracking error or create smarter-beta benchmarks based on equal-, value- or risk-weighted components, and with explicit mechanisms designed to avoid concentration risk. These solutions might be slightly more expensive than a typical passive index, but we think it’s a price worth paying to avoid the risks of a pure, cap-weighted approach. And it’s probably a better idea than giving a monkey some darts and a copy of the FT.
Like most forms of risk and biases, our goal as systematic traders is not to completely avoid them, but to simply be aware of them. Understanding concentration risks can have a major impact on basic trading system design.