Would A Monkey Picking Stocks Outperform A Hedge Fund Manager?

The question of whether a monkey picking stocks could outperform a hedge fund manager is a fascinating thought experiment often used to highlight the challenges of beating the market.

It seems likely that, on average, random stock selection could indeed outperform a typical hedge fund manager, especially over long periods, due to the high fees and inefficiencies many hedge funds face.

Key takeaways

• Research suggests a monkey picking stocks (random selection) is likely to outperform a typical hedge fund manager, given that most hedge funds underperform the market due to high fees.
• The evidence leans toward a probability of around 60–70% for random selection outperforming, based on historical data and studies, though exact figures vary by period and conditions.
• There is controversy, as top hedge funds may outperform in specific scenarios, but for average managers, random selection often does better.

Why Random Selection Might Win

Studies and experiments, such as Warren Buffett’s famous bet from 2008–2017, show that low-cost index funds (like the S&P 500) often beat hedge funds, which suggests that random portfolios, with no fees, might do similarly well or better.

For example, research from Nasdaq indicates that random stock picking has historically beaten fund managers in some cases, and Business Insider reports British researchers found monkeys outperformed the market over time in simulations.

Probability Estimate

While exact probabilities are hard to pin down, the evidence suggests a random portfolio has about a 60–70% chance of outperforming a typical hedge fund manager over a 10-year period, based on historical underperformance of most hedge funds (only about 10% beat the market long-term) and the potential for random selection to match or exceed market returns.

Considerations

This comparison can vary by market conditions and time frames, and top hedge funds may still outperform, but for the average manager, the odds favor the monkey. This highlights the importance of low-cost, passive investing strategies for many investors.

Also, the comparison might not be relevant. A hedgefund might have little correlation with the stock market, and thus make it very worthwhile for diversification purposes despite having lower returns.

Comprehensive Analysis

This section provides a detailed examination of the comparison between a monkey picking stocks (random stock selection) and the performance of hedge fund managers, drawing on historical data, academic studies, and industry analyses to address the likelihood and probabilities involved.

Background and Context

The concept of a “monkey picking stocks” is a metaphorical way to explore random stock selection, often used to test the efficient market hypothesis, which suggests that stock prices reflect all available information, making it hard for even professionals to consistently outperform.

Hedge fund managers, on the other hand, are professional investors who manage pooled funds using sophisticated strategies, such as long/short equity, global macro, and event-driven approaches, aiming for absolute returns. However, they typically charge high fees (e.g., 2% management fee and 20% performance fee), which can erode net returns for investors.

The comparison is particularly relevant given the ongoing debate between active and passive investing.

Historical data shows that most active managers, including hedge funds, struggle to beat broad market indices like the S&P 500 over long periods, especially after accounting for fees. This raises the question: could a random, fee-free strategy (like a monkey throwing darts at a stock list) actually do better?

Historical Evidence and Studies

Several studies and experiments provide insight into this comparison:

• Warren Buffett’s Bet (2008–2017): In a well-documented bet, Warren Buffett challenged Protégé Partners to select five hedge funds-of-funds, which in turn invested in over 200 hedge funds, expecting them to outperform a low-cost S&P 500 index fund over 10 years. The results, detailed in AEI, showed the S&P 500 index fund returned 125.8%, while the best hedge fund-of-funds returned only 36.3%, with others performing worse. This highlights the drag of fees and the difficulty hedge funds face in beating the market.
• Random Stock Picking Experiments: Various experiments have tested random stock selection against professional managers:
  • Nasdaq reported that David Harding of Winton Capital, a major hedge fund, found that randomly picking 50 stocks and weighting them equally outperformed the S&P 500, citing lower transaction costs as a factor.
  • Business Insider discussed a British study where researchers concluded that monkeys, over time, were better at picking stocks than the market, based on simulations from 1968–2011.
  • The Wall Street Journal’s “Dart Throwing Chimp” contest, mentioned in Market Sentiment, showed instances where random selection beat professional investors over short periods.
• Academic Research: Bayes Business School conducted research finding that random stock-picking simulations outperformed traditional market capitalization-weighted indices every time over 1968–2011, supporting the idea that random portfolios can do well.
• Industry Performance Data: Investopedia noted that from January 1994 to June 2023, the S&P 500 outperformed every major hedge fund strategy by over 2.8 percentage points annually, underscoring the underperformance of hedge funds relative to passive strategies.

Probability Analysis

Estimating the probability that a random portfolio outperforms a hedge fund manager requires considering several factors:

• Hedge Fund Performance Distribution: Studies suggest that only about 10–15% of hedge funds consistently beat the market over long periods. For example, NGPF reported that 93% of investment pros underperformed, implying only 7% beat the market, and similar trends are seen for hedge funds in Reddit discussions.
• Random Portfolio Performance: A random portfolio, by definition, has an expected return close to the market average (e.g., S&P 500) if well-diversified, with no fees. Given the positive skewness of stock returns (as noted in Quantitative Finance Stack Exchange), the median performance might be worse than the mean, but over long periods, it has roughly a 50% chance of beating the market, assuming symmetry for simplicity.
• Comparison Logic: Since most hedge funds underperform the market due to fees and other inefficiencies, a random portfolio, with no fees, has a higher likelihood of outperforming. For instance:
  • Suppose 90% of hedge funds underperform the market, and a random portfolio beats the market 50% of the time. In that case, the probability that the random portfolio outperforms a randomly selected hedge fund is greater than 50%, potentially around 60–70%, accounting for the fact that many hedge funds will have lower net returns.
• Simulation-Based Insights: Portfolio Optimizer discusses using random portfolios for hedge fund benchmarking, calculating p-values to assess performance significance. For example, with 1000 simulated random portfolios from S&P 500 stocks (2005–2010), the 95th percentile return was used as a benchmark, suggesting that outperforming this threshold is statistically significant. This methodology implies that random portfolios can serve as a tough benchmark, and many hedge funds fail to beat it.

Detailed Comparison Table

To illustrate the performance gap, consider the following data from Buffett’s bet and related studies:

Metric	Hedge Funds (Average)	S&P 500 Index Fund	Random Portfolio (Estimated)
Average Annual Return (2011–2020)	5.0%	14.4%	~10–12% (market average, no fees)
End Value of $100,000 Investment (2011–2020)	$159,982	$364,678	~$310,000 (hypothetical, no fees)
Buffett’s Bet Result (2008–2017)	Trailed in 9 of 10 years	Beat hedge funds-of-funds	N/A (not directly measured)
Fees	~2.5% fixed + 20% performance	0.04% (e.g., Vanguard)	0% (no fees)

This table, sourced from AEI, shows the significant impact of fees on hedge fund returns, making random portfolios more competitive.

Controversies and Limitations

While the evidence leans toward random selection outperforming, there are caveats:

• Top Hedge Funds: Some top hedge funds, like those in the Top 50 list from Hedgeweek, have outpaced the S&P 500 by 3% over five years (through 2022), suggesting that elite managers can beat the market, especially in bear markets.
• Market Conditions: Random portfolios may underperform during volatile periods if they hit on high-risk, low-return stocks, while hedge funds with hedging strategies might protect capital better.
• Time Frame Sensitivity: Short-term results can vary widely, with random portfolios sometimes beating professionals by luck, as seen in short-term experiments like the Wall Street Journal’s dart-throwing contests.
• Correlations and diversification: this might make hedge funds very useful despite lower returns (as a portfolio).

Conclusion

Given the historical underperformance of most hedge funds against market indices, and the evidence from simulations and experiments showing random portfolios often outperforming, it seems likely that a monkey picking stocks would outperform a typical hedge fund manager.

The probability is estimated at around 60–70% over long periods (e.g., 10 years), reflecting the drag of fees on hedge funds and the potential for random selection to match market returns. However, this is context-dependent, and top hedge funds may still excel in specific scenarios.