That fund managers rarely beat the S&P 500 is Wall Street's worst kept secret, but until recently, it has been assumed that the index fund is a better option than simply picking stocks at random. Back in July, however, CNBC reported that David Harding of Winton Capital (the world's 14 th largest hedge fund) was pointing out that this was not necessarily the case.
This, from Harding: "The S&P 500 is a trading system. The S&P 500 is a set of rules for buying and selling stocks. It's a trading system, and by the way-it's not a very good one." Thinking he could improve upon the S&P 500, Harding decided to pick 50 stocks at random. "You choose stocks at random and weight them equally. We tested the idea and immediately did better than the S&P 500."
As stated, the above argument scarcely addresses, and certainly doesn't prove the real point. It makes no difference whether Harding did better or worse than SPDR S&P 500 (spy), the S&P 500 Index fund, with a particular instance of randomly picked stocks. What we want to know is whether randomness is better, on average, than averageness. It seems like a safe bet that given enough instances, the random stock picking strategy would simply regress to the mean, and therefore be equal to SPY. It also seems like the world is flat, but in both cases, it ain't so.
In the real world, stock transactions have a cost-two costs, actually. First, most of us, not being market makers, pay transaction fees, and second, the spread between bid and ask is always there, exacting a tiny rake from each stock transaction. There's no complaint here; this little rake is what makes the existence of the stock market possible, but it is very real, and the more actively one manages ones portfolio, the more one pays. With 500 underlying stocks in need of constant reweighting, SPY ends up paying far more than a random portfolio of stocks.
One final assumption is needed to prove my premise: that monkeys who pick stocks will necessarily do so at random. Let's hope that's always true, because the moment they begin to have ideas of their own, they will lose their advantage. Also, they'll probably want a fee.
Julian Close has been a business writer since the first day of the twenty-first century, having written for PRA International and the United Nations Department of Peacekeeping. He graduated from Davidson College in 1993 and received a Master of Arts in Teaching from Mary Baldwin College in 2011. He became a stockbroker in 1993, but now works for Fresh Brewed Media and uses his powers only for good. You can see closing trades for all Julian's long and short positions and track his long term performance via twitter: @JulianClose_MIC .
This article was originally published on MarketIntelligeneCenter.com
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