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Monkey Business

On a recent trip to the zoo I found myself watching the capering antics of energetic monkeys. Or at least thatís what I would have seen if the monkeys werenít all soundly asleep. Finding myself suddenly bereft of entertainment, the monkeys got me thinking about their infamous stock picking relatives.

Proponents of efficient markets and index funds often point to the efficacy of hiring monkeys to pick stocks. It seems that every year humorous contests are held which pit human portfolio managers against the random stock picks of monkeys. The thing that makes these contests entertaining is that the monkeys often do quite well.

Aside from starring in humorous contests, the monkeys deliver an implicit message. Namely, donít bother hiring expensive portfolio managers; just buy low-cost index funds.

Of course, there are more serious reasons to buy index funds. Most importantly, good index funds charge super-low fees and, like the random picks from our simian friends, often beat actively managed mutual funds. The fee difference between regular mutual funds and index funds can be astounding and it is thought to be the primary reason for the good relative performance of index funds. For instance, the iUnits Composite Canadian Equity Index Fund charges 0.25% per year whereas many popular actively-managed Canadian equity funds charge more than 2.50% per year. Such equity funds charge at least ten times more than the index fund but both provide investors with a diversified portfolio of Canadian stocks.

Can an active fund that charges ten times as much as an index fund be expected to outperform the index fund? The case could be made in extraordinary circumstances, but it might be more fruitful to see if index funds themselves could be made even better. Interestingly those clever monkeys might have had the answer all along.

Letís take a step back and learn how a regular index is put together by studying the popular S&P500 index which tracks 500 large companies in the United States. By large, Iím referring to market capitalization which is equal to a companyís share price times its total share count. For instance, Coca-Cola (KO) has about 2.38 billion shares and trades at $41 per share, which makes its market capitalization $97.58 billion (2.38 billion times $41). While Coca-Cola is one of the biggest stocks in the S&P500, some of the smallest stocks in the index, such as Applied Micro Circuits, have market capitalizations near $1 billion. The catch is that while the S&P500 follows 500 stocks, it doesnít hold an equal percentage of its portfolio in each stock. Instead, the index holds an amount of each stock in proportion to that stockís market capitalization. The index puts almost 100 times as much money in Coca-Cola as it does in Applied Micro Circuits. Similarly when you buy a S&P500 index fund, youíll actually be getting more of each large stock and much less of each small stock.

This is where the monkeys come in. When the monkeys pick stocks they arenít smart enough to calculate market capitalization and instead just buy an equal amount of each stock that they select randomly. The monkey version of the S&P500 would hold an equal amount of each stock (1/500th or 0.2% in each stock) and it is said to be equally-weighted whereas the regular S&P500 is market capitalization-weighted.

Not to be outdone by monkeys, the smart people at Standard & Poorís also track an equally-weighted version of the S&P500. Hereís the rub. The equally-weighted S&P500 returned 12.00% annually over the last 10 years (ending February 1, 2006) but the regular S&P500 returned only 8.99% annually. So, the monkeysí equally-weighted S&P500 outperformed the regular S&P500 by a whopping 3.01 percentage points annually.

Why did the monkeys do so well? By buying equal amounts of each stock they were effectively putting more money into small value stocks than the regular index. In recent years, and over the very long term, small value stocks have tended to outperform their larger more growth-oriented brethren.

So, with tongue firmly planted in cheek, if you own regular index funds, do you really want to be beaten by a bunch of monkeys? Perhaps itís time to tell your regular index funds that youíve opted for monkey management instead?

You can certainly make the switch from market capitalization weighted indices to equally weighted indices in some cases. Once again the S&P500 is a good example and you can buy the Rydex S&P Equal Weight (RSP) exchange-traded fund that tracks the equally-weighted S&P500 index. The Rydex fund charges an annual fee of 0.40% which makes it more expensive than regular S&P500 exchange-traded funds. Unfortunately, equally-weighted index funds are simply not available for all indices.

Before you swing to the new breed of index funds, there are a few things to keep in mind. First, equally-weighted index funds are typically more expensive than regular market-cap-weighted index funds. Second, equally-weighted index funds rebalance their portfolios regularly (often quarterly) in an effort to stay equally weighted. After all, if you put an equal amount of money into ten stocks at the beginning of a year, they arenít likely to be worth the same amount at the end of the year. This rebalancing act requires extra trading which will trigger brokerage fees and capital gains taxes and make equally-weighted index funds less efficient than regular index funds. One of the benefits of regular index funds is their ability to buy a stock and simply hold it for long periods of time, which tends to defer capital gains. Third, just because the equally-weighted index funds have outperformed over the last ten years doesnít guarantee that theyíll continue to do so. There will be periods in which regular index funds will outperform. Also equally-weighted index funds can only manage limited amounts of capital because only so much money can be plowed into smaller stocks without changing their prices. While equally-weighted indices arenít without their warts, they are an interesting option for index investors.

The cost-conscious investor can also cobble together a lower-cost more-equally-weighted index fund portfolio by buying a regular index fund and then adding an appropriate value-oriented index fund. Sticking with the S&P500, one could buy equal amounts of the SPDRs (SPY) exchange-traded fund with an annual fee of 0.11% and the iShares S&P 500 Value Index (IVE) exchange-traded fund with an annual fee of 0.18%. The combination of 50% SPY and 50% IVE would have an effective annual fee of 0.145% which is much less than the Rydex S&P Equal Weight (RSP) fund's fee of 0.40%. Naturally the SPY/IVE combo is only a very rough approximation to the equally-weighted index fund but the lower fees make the combo an interesting alternative. As an added bonus the percentages assigned to each ETF can be varied to better reflect one's taste for smaller value stocks.

While many investors buy index funds for their relative simplicity, it shouldn't stop them from considering similar low-cost strategies. Aside from stock selection, curiosity is another essential trait that should be picked up from those friendly monkey managers.

First published in March 2006.

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