From the May 2007 issue of Wealth Manager Web • Subscribe!

May 1, 2007

Malkiel Speaks

Endorsing indexing required something of a leap of faith (and perhaps a bit of ego) in the days when Nixon was in the White House, gasoline was 40 cents a gallon, and active management was universally perceived as the accepted wisdom for running investment portfolios. The finance establishment wasn't ready for passive money management when Burton Malkiel's A Random Walk Down Wall Street debuted in 1973. But it's a very different story today.

To say that things have changed since the book's first edition is understatement in the extreme. Indexing is now widely embraced--or so it appears, based on the trillions of dollars sitting in funds that seek no greater performance glory beyond reducing tracking error relative to an appointed benchmark.

When Random Walk first appeared on bookshelves more than 30 years ago, the theoretical foundations of indexing had been percolating for years from a number of sources. Yet it was Malkiel, a Princeton economics professor, who introduced the subject to the masses by distilling what was an array of academic papers into an engaging book about investing for individual and institutional investors alike.

Indexing, in its various forms, has been on a roll ever since. And so has the book, which has remained a staple for exploring the finer points of indexing as investing's salvation.

Given the recent explosion of interest in ETFs, it seems fitting that Random Walk has been updated once again. The ninth edition was published this past February by Norton, offering a fresh excuse to chat with Prof. Malkiel about his tome's latest incarnation and indexing in general.

The first edition of your book was published in 1973, and the ninth edition hit the streets earlier this year. What's changed with indexing in the intervening 34 years?

In one sense, nothing's changed and in another sense, everything's changed.

What hasn't changed is my view that index funds can play an important role in every portfolio--for individuals and institutions. My view on that is even stronger than when the book was first published because we've got 30 years of experience with index funds.

One of the things I do in the book's new editions is answer the question: Has indexing worked? The evidence that's accumulated shows that indexing works, and it works brilliantly. Everybody should, at the least, index the core of any portfolio. Perhaps you want to go around the edges and take a flyer on something. Or, maybe there's an active manager that you like. Fine. But you can do it with much less risk if you index the core portfolio. By the way, indexing isn't an average strategy; it's an above-average strategy because the costs are so much less [than active management].

What has changed since the first edition?

When I think of what existed in 1973, and what exists now, it's night and day. First of all, index funds didn't exist then. Today, we have hundreds of index funds. And the biggest part of the financial market--the growing part--is the market for exchange-traded funds, which are index funds.

Money market funds didn't exist either in 1973. Municipal bond funds didn't exist. Municipal bond funds by state didn't exist. Real estate investment trust funds didn't exist. The 529 College Savings Plans didn't exist. The products available for investors now are very, very different.

What are some of the new edition's highlights?

There are two new chapters in the ninth edition. One is looking at behavioral finance and discussing the lessons for individual investors. There are some systematic errors that individual investors make, and so focusing on them is helpful. If you can avoid some of the behavioral mistakes, you're way ahead of the game.

For example?

Over the long run, the stock market generated a rate of return in the vicinity of 10.5 percent a year. But the average investor doesn't get anything like that because the average investor tends to put his or her money into the stock market at the peak. More money came into equity mutual funds during the fourth quarter of 1999 and the first quarter of 2000 than ever before. More money left equity mutual funds in the third quarter of 2000 than ever before. The money comes in at the peak and seems to go out at the trough.

In fact, when the money was coming in at the end of 1999 and the beginning of 2000, people weren't buying value funds, which were cheap. No--money was pouring out of the value funds and going into the high-tech Internet funds. It's all part of behavioral finance--there's a herd instinct.

I remember people telling me in late 1999 that nobody was ever going to go to a mall any more. All the shopping would be done on the Internet. I remember some in my own family saying at the end of 1999, "You gave me lousy advice and put me in this index fund, and the high-tech funds did much better last year." Of course, over the next five years [the high-tech funds] did remarkably worse.

What else is new in the ninth edition?

Another addition focuses on the changes in demography. The boomers are about to retire. I really didn't have anything in previous editions about how to invest in retirement, how to withdraw money, whether you should buy annuities--things like that. There's a new section for investing in retirement.

When you wrote the first edition, publicly available index funds didn't exist. What did you advise investors to buy?

I recommended closed-end funds, which were selling at 70 cents on the dollar at the time. It's not that I thought they'd beat the market. But if you can buy assets at 70 cents on the dollar, you'll probably do pretty well. In fact, the [closed-end] managers didn't do any better than the market, but investors did [if they bought closed-end funds at discounts to net asset values and profited from the narrowing of the discounts]. One of the things that might have been instrumental in closing those discounts was the publicity that I gave it.

But it was tough in the beginning to think of what people ought to do. From the very beginning, I indicated that if you want to use actively managed mutual funds, you should find ones with low expenses and low turnover ratios. The best way to get top-quartile performance among actively managed mutual funds is buying funds with bottom-quartile expense ratios and bottom-quartile turnovers.

In the three decades since the first edition of your book, one could argue that the evidence has become more compelling that indexing is a winning strategy over time. Yet active management seems as popular as ever.

Some people ask, "Are you disappointed?" I'm not disappointed at all. I think of the glass as half full rather than half empty. First, institutional investors now index between a third and 40 percent of their portfolios. More professional investors have accepted indexing. For individuals in the mutual fund area, something like 17 percent of portfolios is indexed.

Is that too low? Sure. The reason it's too low is [related to] the basic conflicts of interest in this game. The broker makes money by suggesting something on which he or she is going to make a commission. That's the basic problem of why there's been so little [indexing].

Still, I'm excited that there's even a 17 percent rate of indexing among individuals. Am I surprised that it's not higher? No, because no one's going to try to sell you an index fund because there's nothing in it for [the brokers]. Any securities person is going to sell the product that's going to make them the most money.

Broad diversification and low cost are the answers, but low cost is anathema to advisors who are trying to maximize their income. I think that's the conflict. I remind readers that there are inherent conflicts on Wall Street and that you need to protect yourself from the conflicts.

Some of the conflicts are minimized if brokers are selling ETFs. Then again, critics charge that some brokers are simply pushing the hot ETF du jour--a bias that takes a toll on long-term results.

I love ETFs, but if they just push you to buy and sell ETFs and move from one hot area to another, the advice is likely to be wrong as often as it's right--if not more often than it's right. So there still could be a conflict of interest [with ETFs]. If you really need professional investment advice, go to a fee-only advisor. Interestingly, the fee-only advisors are the best proselytizers for indexing.

Speaking of indexing, what's your take on fundamental indexing and the expanding supply of ETFs tied to these benchmarks, which are being promoted as superior to the traditional capitalization-weighted indices such as the S&P 500? Is fundamental indexing a better way to index?

First of all, I don't think [fundamental indexing] is indexing; it's making a bet. It's active management. Of course, it's made a particular bet that's worked out very well over the past five years.

Fundamental indexing is a particular bet on pushing your portfolio toward smaller size and value, meaning low price-to-book and low price-to-earnings stocks. You get into value stocks with fundamental indexing because one of the fundamental factors is earnings. If you weight by earnings rather than by price, the high price-earnings-multiple stocks are underweighted relative to a cap-weighted index.

Fundamental indexing has worked extraordinarily well because we came out of a bubble in early 2000, and it's been exactly the right thing to do. The problem I have with it is that price-earnings multiples are so compressed now that it may be the growth stocks that are really cheap rather than the value stocks. Large-cap stocks could represent the best value.

Owning an index fund for exposure to equities is one thing. But isn't it important to own a mix of asset classes and rebalance periodically to take advantage of volatility?

I think that's right. I emphasize rebalancing in the ninth edition. Let me tell you a quick story. I ran some calculations for a pension fund that wanted an allocation of 50 percent stocks and 50 percent bonds. It was a period when stocks did 10 percent and bonds did 8 percent. I [calculated the numbers on a] 50/50 rebalanced portfolio over a 10-year period and it returned 9.4 percent--not 9.0 percent, which is the average between 8 and 10 percent. The pension fund told me, "You made a mistake." I said, "No, here's what happened. You started off at 50/50. The stocks then went to 60 percent and the bonds dropped to 40 percent. So you took some equity money off the table and put it into bonds. Later on, interest rates went down and so bonds went up, pushing bonds up to a 60 percent weighting and the stocks down to 40 percent. So, you sold some of the bonds and bought stocks."

It's not that you know it's the low of a market, but that's the advantage of rebalancing, and that's what makes sense. It's absolutely objective and keeps the risk under control. Rebalancing is a very wise strategy.

James Picerno (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.

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