Burton Malkiel on index-based investing and hedge funds

Burton Malkiel’s dedication to his mission to champion index-based investing remains undiminished four decades after he wrote one of the classic finance texts. 

A Random Walk Down Wall Street, published in 1973, popularised the message that short run changes in stock prices are unpredictable and that trying to beat the market is a fool’s game. The book is written in a direct, non-technical style that reflects the author’s straight talking.

His insights helped pave the way for the launch in 1976 of the first index-tracking mutual fund by Vanguard, where Mr Malkiel served as a director for 28 years.

Decades of experience have strengthened the veteran’s conviction that the core of every portfolio should consist of low-cost index funds.

“I’m extremely sceptical that anyone can do stockpicking well. The evidence is clear that simple low-cost index funds have outperformed 90 per cent actively managed funds over 10 years. A precious few stockpickers do outperform but there is no way to know in advance who they might be,” he says on a visit to London to promote a new index-tracking fund.

Index-tracking strategies account for about 40 per cent of US mutual fund assets and a rising share of investment inflows in Europe and Asia. This has sparked concerns that the growth of passive funds could mean stock markets become less efficient as mechanisms for capital allocation.

“Can passive become too big? No. The fact that most investors will be indexing will not be a problem,” he says.

Active managers will retain a role to ensure that asset prices reflect fundamentals but they will shrink in number as more investors adopt index-tracking.

“There are still too many active managers,” says Mr Malkiel, who at 86 years old is chief investment officer of Wealthfront, an $11bn California “robo-adviser” that constructs portfolios from exchange traded funds.

His scepticism about active management extends to lucratively rewarded hedge fund managers.

“Hedge funds that take concentrated positions have a lousy record and I wouldn’t invest in those. I’m very suspicious of the long-short guys but I would not tar all alternatives with the same brush. Real estate and venture capital make a lot of sense for those people that can stand the illiquidity of those investments,” he says.

The 12th edition of Random Walk was published three weeks ago with a new chapter on smart beta, one of the hottest areas of innovation in asset management. Smart beta strategies aim to exploit longstanding pricing anomalies, such as investors’ tendency to underprice smaller companies.

“Single factor smart beta funds are not smart investing. Value strategies can go six or seven years without outperforming. But I have a much more favourable view of multifactor strategies, which do offer the possibility of reducing portfolio risks,” he says.

The growing popularity of index-based investing has helped BlackRock and Vanguard develop into the world’s two largest asset managers. Both regard themselves as permanent shareholders in the world’s largest listed companies. Critics argue that the big two have failed to use their voting powers to influence companies’ policies on issues such as excessive pay awards to executives and the fight against climate change.

These criticisms cut no ice with Mr Malkiel, who retains his position as a professor of economics at Princeton University. “They [BlackRock and Vanguard] take an even greater responsibility with their holdings as permanent shareholders. I think it makes them better investment stewards,” he says.

A growing number of investment managers offer specialised funds that use environmental, social and governance metrics to score companies. This development leaves Mr Malkiel unimpressed.

“I have never found an ESG fund that would really make me feel good. Is Lockheed Martin a ‘bad’ company because it makes weapons that kill, or a ‘good’ company because it makes missile defence systems? My problem is that so much of ESG is based on judgment calls,” he says.

Climate change poses profound challenges to all economies but Mr Malkiel cautions that combining environmental and financial metrics is not straightforward. “Should we sell Chrysler because its most popular product is a gas-guzzling Jeep and buy Tesla? Is one oil company really better [environmentally] than another? Companies do so many different activities that it is very hard to construct a portfolio that provides an effective solution to global warming.”

Mr Malkiel sees parallels with the difficulties faced by Princeton’s endowment during South Africa’s apartheid era, when students demanded that it exit from international companies operating there. “Having multinationals working in South Africa was a force for change. IBM was one of the best corporate citizens, giving money to improve the education of black students,” he says.

Mr Malkiel, a card-carrying Republican who served for three years as a first lieutenant in the US army finance corps in the 1950s, is concerned that President Donald Trump’s trade war with China could damage global growth. “This [trade war] could hurt the world economy. The reason we want to trade is that it can make both parties better off. It is a positive sum game,” he says.

Mounting concerns about the trade war and uncertainty over the path of US interest rates weighed heavily on Wall Street last year. The benchmark S&P 500 index registered its first annual decline since the financial crisis in 2018, reflecting pessimism about the outlook for US corporate earnings.

Mr Malkiel’s advice is to ignore swings in short-term sentiment and to follow the ideas that he has supported over half a century. “What you shouldn’t do is panic and sell out. It is invariably a mistake.”

He adds: “Rather than trying to find undervalued US stocks, maybe the best solution would be to buy and hold an index comprising all the securities available for investment globally.”

Profile: Wealthfront

Assets $11bn for about 250,000 clients

Founded Co-founded in 2010 by Andy Rachleff (chief executive) and Dan Carroll (chief strategy officer)

Number of employees 150

Headquarters Redwood, California

Ownership Co-founders, employees and 38 venture capital investors

Burton Malkiel CV

Born August 28 1932 Boston, Massachusetts

Education Various years 1943-64 Boston Latin School, Harvard, Princeton

Career 1955-58 US army finance corps; 1958-60 associate, Smith Barney & Co; 1964-81 various roles in economics department, Princeton, including director of financial research centre, professor and chairman; 1975-77 member of the Council of Economic Advisers to the US president; 1977-81 chairman, economics department, Princeton; 1981-88 dean, Yale school of organisation and management; 1988-2012 professor, economics department, Princeton; 2012-present senior research economist, Princeton; 2012-present chief investment officer, Wealthfront