For over four decades, Burton Malkiel has advocated for broad passive exposure to financial markets. More recently however, this Princeton professor and author of the best-seller book ‘A random walk down Wall Street’ has also been recommending a prudent and low-cost approach to factor-based strategies. Although his views may not necessarily match those we share at Robeco, we consider this as a very interesting development. In our Great Minds series – a set of interviews with renowned academics and investment experts – we talked to him, about passive investing, smart beta, and more generally his most important professional achievements.
The popularity of passive investing has grown tremendously over the past decades, to the point that some academics and practitioners fear it may have damaging consequences on the way financial markets operate. Do you share those concerns? Is there an optimal level for passive investment?
“No, I don’t share these concerns. I am not sure whether you are aware of this study, but S&P Dow Jones Indices, the index provider, publishes a report every six months on active versus passive management in the United States. And interestingly enough, the findings tend to be the same every time. In any given year, two thirds of active managers are outperformed by a low-cost indexing strategy. And if you go back ten and fifteen years – Standard and Poor’s has been doing this for that long – as many as 90% of active managers were outperformed by passive indices. This is not only true for large-capitalization stocks, but also for small-cap stocks. It is even true for the less efficient emerging markets, where passive investing has shown itself to be effective.”
Still, in a recent article published in The New York Times1 , you seemed to be slightly tweaking your message on passive and advocating some kind of factor-based, or ‘smart beta’, approach. Specifically, they called you “an index fund evangelist who is straying from his gospel”. Could you explain that?
“Sure. First of all, I think the reporter’s impression was not really accurate, because he was suggesting that I had given up on passive. In my book, I had used a metaphor that a blindfolded chimpanzee could pick stocks as well as the experts, and the reporter suggested I had given up on the monkeys. That’s not really true. Having said that, I have done quite a bit of work on some of the newer methods of portfolio management. And, as you can imagine, this is just the beginning.”
“So let’s talk about smart beta. One of the things that we’ve learned from the academic research is that the so-called Capital Asset Pricing Model (CAPM), where risk is only one variable involved in relative volatility, is not a sufficient model. What we know is that there are probably many sources of risk. In other words, the CAPM beta, which is just volatility, is not sufficient. What smart beta says is that you can tilt a portfolio in certain ways, such as buying more of these low valuation stocks, such as buying small-capitalization stocks. And the claim is that you can get a higher rate of return. It is compensation for taking on more risk, but that’s fine if the investor can take on more risk.”
OK. But then, what’s your view on the current smart beta offering?
“In general, I have not been a fan of smart beta for the following reasons. Not that the academic work does not support it, it absolutely does. But most of the smart beta offering has very high expense ratios, despite the fact that a lot of these products are ETFs. The second point I want to raise is that all of these factors never work all the time. The low valuation effect has worked most of the time through history, but you could well go through four or five years where it doesn’t not work. So, what I usually recommend, and it has worked reasonably well, is not to use just one factor. We can use a number of factors and, hopefully, what happens is when one factor is not working another factor is likely to be working.”
Given the current popularity of factor investing and smart beta strategies, many sceptics have warned that excessive bets could lead to the disappearance of premiums. Could factor premiums be arbitraged away, in your view?
“Well, there is that possibility. If a given factor becomes too popular, the premium should decline. Actually, some premiums may well have declined somewhat already, and that’s an important factor to take into account. Whenever an investment idea becomes overly popular, we cannot, we should not expect that it will continue to have the same beneficial effects as in the past. That being said, my sense is also that, if these really are a compensation for risk, they will not disappear completely.”
For now, would you worry about a potential overcrowding of these products?
“Not yet. But, in that respect, I will draw a parallel with your first question concerning the optimal level of passive investing. Imagine everybody used smart beta approaches, instead of general broad-based passive investing strategies. Well, in that case, I suspect smart beta would certainly not be nearly as beneficial now as it might have been at the very beginning.”
I worry a lot that most people do not diversify enough
How do you view traditional diversification over asset classes, countries or sectors, for example? Should investors also stick to this kind of approach?
“Absolutely, absolutely. There’s an expression often used by economists that diversification is the only free lunch that’s available in investment markets. And I actually worry a lot that most people do not diversify enough, that people have what’s called a home-country bias. And I think this home-country bias is a mistake too many people make.”
On a final note, if you could give investors one piece of much needed advice, what would it be?
“That one should be very skeptical of anybody who says: ‘I am going to charge you a lot of money but I am going to do a way better job investing for you’. Avoiding that, avoiding the people that come to you and say: ‘I am going to make you a millionaire because you can buy bitcoins and they do nothing but go up’. Avoiding mistakes, steering a steady course, being well-diversified and remembering that the costs really do matter.”
This article is an excerpt of a longer text published in our Robeco Quarterly magazine. Read the full article here.
1 J. Stewart, « An Index-Fund Evangelist Is Straying From His Gospel », The New York Times, 22 juin 2017.