Why the Monkey Might Win

By Mark F. Toledo, CFA

August 1, 2017

Can blindfolded monkeys throwing darts at pages of stock listings to select portfolios that will do just as well, if not better, than both the market and the average portfolio constructed by professional money managers?

The Dart Board

Exhibit 1: US Stocks Sized by Market Capitalization

Exhibit 1 shows the components of the Russell 3000 Index (a proxy for the US stock market) as of December 31, 2016. Each box represents a stock in the index. The size of each box signifies the stock’s market capitalization weight in the index.

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For example, the largest box represents the largest company - Apple (AAPL). The boxes get smaller as you move from the largest cap stocks at the top to small caps at the bottom. The colors differentiate equity market segments- large cap value stocks (LV), large cap growth stocks (LG), small cap value stocks (SV), and small cap growth stocks (SG).*

This exhibit also represents a proxy for the aggregate portfolio for all investors. For every investor choosing to “overweight” a stock relative to its market cap weighting in the index, another investor must “underweight” that same stock. Therefore, the aggregate portfolio for all investors looks like the overall market.**

Exhibit 2. US Stocks Sized Equally

Exhibit 2, on the other hand, represents the dart board the monkeys use to play their game. Here, the boxes represent the same stocks shown in Exhibit 1, but instead of weighting each company by market cap, the companies are weighted equally.
For example, in this case, Apple’s box is the same size as every other company in the index regardless of its market cap. If one were to pin up pages of newspaper stock listings as a dart board, Exhibit 2 would be much more representative of what the target would look like.

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Different Dart Boards, Different Results

When looking at Exhibits 1 and 2, the significant differences between the two are clear. In Exhibit 1, the surface area is dominated by large value and large growth (blue and green) stocks. In Exhibit 2, however, small cap value stocks dominate (gray).

Why does this matter? Research has shown that, historically over time, small company stocks have had excess returns relative to large company stocks. Research has also shown that, historically over time, value (or low relative price) stocks have had excess returns relative to growth (or high relative price) stocks. Because Exhibit 2 has a greater proportion of its surface area dedicated to small cap value stocks, it is more likely that a portfolio of stocks selected at random by throwing darts would end up being tilted towards stocks which research has shown to have had higher returns when compared to the market.

This does not mean, however, that haphazardly selecting stocks by the toss of a dart is an efficient or reliable way to invest. For one thing, it ignores the complexities that arise in competitive markets.

Consider, as an example, something seemingly as straightforward as a strategy that holds every stock in the Russell 3000 Index at an equal weight (the equivalent of buying the whole dart board in Exhibit 2). To maintain an equal weight in all 3,000 securities, an investor would need to rebalance frequently, buying shares of companies that have gone down in price and selling shares that have gone up. Price changes drive these transactions by altering each individual holding’s respective weight in the portfolio. By not considering whether or not these frequent trades add value over and above the costs they generate, investors are opening themselves up to a potentially less than desirable outcome.

Instead, a systematic and purposeful approach that takes into consideration factors that explain differences in expected returns across stocks and real-world constraints could increase your chances for investment success. Considerations for such an approach include: understanding the drivers of returns and how to best design a portfolio to capture them, determining a sufficient level of diversification, how to appropriately rebalance, and last but not least, how to manage the costs associated with pursuing such a strategy.

The Long Game

Finally, the importance of having an asset allocation well suited for your objectives and risk tolerance, as well as being able to remain focused on the long term, cannot be overemphasized. Even well-constructed portfolios pursuing higher expected returns will have periods of disappointing results. We can help you decide on an appropriate asset allocation, stay the course during periods of disappointing results, and carefully weigh the considerations mentioned above to help you decide if a given investment strategy is the right one for you.

Conclusion

So what insights can investors glean from this analysis? First, by tilting a portfolio towards sources of higher expected returns, investors can potentially outperform the market without needing to outguess market prices. Second, implementation and patience are paramount. If one is going to pursue higher expected returns, it is important to do so in a cost-effective manner and to stay focused on the long term.

Mark F. Toledo, CFA is a Partner at Chicago Partners Wealth Advisors. He has been a wealth manager for over 35 years and has helped hundreds of individuals and foundations create better wealth management solutions.


*Large cap is defined as the top 90% of market cap (small cap is the bottom 10%), while value is defined as the 50% of market cap of the lowest relative price stocks (growth is the 50% of market cap of the highest relative price stocks). The determinations of Large Value, Large Growth, Small Value, and Small Growth do not represent any determinations Dimensional Fund Advisors may make in assessing any of the securities shown.

**For more on this concept, please see “The Arithmetic of Active Management” by William Sharpe.

IMPORTANT DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners  Investment Group LLC-“CP”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from CP.  Please remember that if you are a CP client, it remains your responsibility to advise CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. CP is neither a law firm nor a certified public accounting firm, and no portion of the blog content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request. Please Note: CP does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to CP’s web site or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.

May 10, 2018

Value vs. Growth

Over the 10-years ending March 31, 2018, the Russell 1000 Value index returned 7.8% per year versus 11.3% for the Russell 1000 Growth index. In contrast, during the 10-years ending March 31, 2008, The Value index returned 5.5% per year versus 1.3% for the Growth index. Over the greater than 38-year life of these indexes, the annualized return for the Value index of 12.1% exceeds the Growth return of 11.4%.

So, what will happen over the next 10-years? Jason Zweig, author of The Intelligent Investor column for the Wall Street Journal, recently concluded an article by stating:


Assuming you do possess the necessary patience and composure, you should tilt your money toward value-oriented investments with low annual expenses that can capture the extra return the strategy is likely to achieve — eventually.

What you shouldn’t do is believe anyone who claims to be able to predict exactly when value investing is about to pay off.1


Over the past several decades, many financial analyst have tried to identify fundamental factors that favor value vs. growth stocks. These factors include interest rate changes, inflation, and the level of economic activity. Zweig quotes Cliff Asness, co-founder of AQR Capital Management as stating that over the long run, “the value factor is not very correlated to macro stuff but works on average.” But there’s a lot of variation in that average, and the long run can be longer than many investors imagine. Along the way, the returns to value investing look “fairly random and unconnected to other things,” says Asness.

We accept the unpredictable nature of when the growth vs. value style of investing will produce superior returns. Benjamin Graham characterized the market as a voting machine in the short-run and a weighing machine over the long-term. This analogy provides an explanation for why momentum works over the short-to-intermediate term and relative valuations over the long-term.

In today’s environment, relative valuations favor value stocks over growth stocks. J.P. Morgan Asset Management publishes returns and valuations by style analysis. The March 31, 2018 analysis contains the following data:2

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This table shows that large cap value stocks currently sell at 14.2 times earnings vs. a 15-year average of 13.2 times- in other words, 107.3% of average. In contrast large growth stocks trade at a 16.2% premium to average. Neither are “cheap” relative to the 15-year average, but the value stocks trade at a lower premium to average.

The difference for small cap stocks offers a greater advantage to the value style. Small cap value stocks sell at approximately 17 times earnings, which is near the 15-year average. Small cap growth stocks are priced at a 21% premium to the long-term average.

The long-term superior return for value vs. growth and the relatively more attractive valuations for the value style do not assure that value will outperform over the next decade. However, these factors do suggest that base case probabilities support a tilt toward value stocks in broadly diversified portfolios.

Mark F. Toledo, CFA is a Partner at Chicago Partners Wealth Advisors. He has been a wealth manager for over 35 years and has helped hundreds of individuals and foundations create better wealth management solutions.


Important Disclosure Information

Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Investment Group LLC (“CP”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CP. Please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. CP is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.