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The Burton Malkiel Interview

Graham Hand: Thanks for signing my copy of Random Walk. Note it is the sixth edition from 1996 so I didn’t just buy it for you to sign. And your book’s now into its 10th edition.

Burt Malkiel: And I’m about to start working on the 11th edition.

GH: Can you tell me what’s changed in investing over the decades since the first edition?

BM: What’s changed is that the first edition, there were no index funds. First edition was in 1973, the first index fund was in 1976. It is meant to be an investment guide, and there have been dramatic changes in the kinds of instruments available to investors.

There are three major things I do in different editions. One, the new instruments available. For example, more recent editions have featured ETFs. Two, the changing regulations like tax laws facing investors. Then finally, the academic research over the period. Two things I will put in the 11th edition are the low volatility products available, and I think that option writing is interesting. I have some colleagues who have done fascinating research that they can replicate the hedge fund index and get 300 to 400 extra basis points by writing puts. You’re basically selling insurance.

You know, in the early days when I said “Just go and buy index funds”, I had a reviewer say in Business Week, “This is the biggest load of garbage”, so I keep saying, “I said go buy index funds, did it work?” and every time I look at the last four or five years, yes it did work. The book has changed a great deal, but the basic message hasn’t changed, even if the advice on what to use has changed.

GH: If I look at some of the criticisms of the book, where people say there are some managers who have had long-term success outperforming the market, but as I read your book, you acknowledge this. For example, in my edition it says, “I walk a middle road. I believe that investors might reconsider their faith in professional advisers, but I am not as ready as many of my academic colleagues to damn the entire field. While it is abundantly clear that the pros do not consistently beat the averages, I must admit that there are exceptions to the rule of the efficient market. Well, a few.” So you’re not just an efficient markets person.

BM: And that was actually another change. I’m not saying you should necessarily index everything, but there’s enough evidence in favour of it, the core of your portfolio ought to be indexed, and then if you want to trial something active around the edges, you do so with much less risk. But just remember, there is this distribution of returns (Burt draws a normal bell curve, then a vertical line near the y-axis representing 1% fees) and if there were no fees, half would be above and half would be below. If you can get the market return, the typical active manager will be 1% less than the market. You’re much more likely to be on the negative side of the distribution with active managers. But you can definitely try it.

I will also be writing about financial repression in the next edition (GH comment: this is where the government interferes with free market operation). I would not buy a bond index fund today.

GH: It’s really interesting to hear that because if we focus on asset allocation rather than manager selection, how do you feel about the various investing models that are recommended to retail clients, say invest 70/30 and stick with that.

BM: There’s no question that in my advice to the Princeton widows, they want to be able to draw some income out without having to sell all the time. They want to do it easily. I don’t want them to get their income from a US bond portfolio, they should get it from emerging markets bonds where there’s no financial repression, or in dividend growth stocks, which takes me back to a low volatility strategy. This is asset allocation, but I don’t feel badly about doing it. If there’s somebody in retirement who wants income, yes, I don’t want them to buy Google and Facebook, I want them to buy a particular type of stock, but that’s fine.

GH: And you also don’t want them to buy a bond yielding 1%.

BM: Exactly, because I think they’re going to get killed.

GH: So in that situation, the so-called lifecycle funds with an increasing allocation to the bond market …

BM: I don’t like them, that’s another thing going into the next edition. I’ve been a director of Vanguard, I’m on the Vanguard International board now, but I don’t like lifecycle funds because at the end, they’re putting 80% into precisely the securities that I think are going to give people an enormous amount of trouble.

GH: Let’s turn to Wealthfront, which looks like it’s gaining some good momentum.

BM: It’s amazing. As I said in the panel discussion, I’m not sure about a lot of things, the only thing I’m absolutely sure about is that the lower the fee I pay, the more there’ll be for me. So what we do at Wealthfront is we’re using the lowest cost ETFs, we are also charging a wrap fee for doing the asset allocation of 25 basis points. So it’s kind of ‘Vanguardising’, if you wish, the advice business. I have been with them since the end of 2012 and they’ve got $210 million of assets from almost nothing in that time. They are doing this using a lot of technology – we’re not going to hold your hand, you can’t do that for this price – and the marketing is done through e-invites, the clients are from places like Google and Facebook and Salesforce and they are happy to be serviced online. I don’t think my Princeton widows would be comfortable with this approach, and if you want to pay more for advice, fine if there’s someone who will hold your hand.

GH: I assume there’s some process of risk assessment.

BM: Yes, we use some of the expertise from behavioural finance people, Meir Statman was one who helped us design the questionnaire so it’s not simply age. That’s too simple, people are all different. There are people for whom a very aggressive portfolio makes them sick to the stomach when it goes down.

GH: They can’t sleep at night.

BM: More than that. They can’t sleep at night, but one of the things we know about the mistakes people make is that they’re more likely to sell when the market falls. They can’t take any more. When people try to time the market, they usually get in at the top and get out at the bottom. You see it with mutual fund flows, you see it with pension funds. Are we doing it perfectly, probably not, this is not an easy thing to do. We have added people who know something about survey techniques, people who know behavioural finance, we get the questionnaire filled out and then we put people in particular buckets.

Just to give you an idea, I’m a client, and given my age, they had me in a safer portfolio than I wanted to be, and I said you can’t just do it with age because I’m not investing for myself, I’m investing for my grandchildren. It’s the horizon of the people you are investing for.

GH: Given your comments about low bond rates, if someone profiled as conservative, where do they go?

BM: As I said, the bonds we are using are bonds from countries not engaged in financial repression, have younger demographics, have reasonable interest rates, low debt and better fiscal balance. I am the Chief Investment Officer and I design these things for exactly the reasons we discussed earlier.

Let me tell you the other things we can do. We do rebalancing with an automatic formula, and for taxable accounts, we do tax loss harvesting. Let’s say you’ve got a US equity position, and the equity has gone down. We’ll sell the Vanguard ETF and buy the Schwab ETF, it is essentially the same thing but it’s not a wash sale when you do it that way, and take the tax loss, and particularly for the clients we have now, they can use the tax loss because their portfolios might be 98% in Facebook stock which they will be taxed on. This works well.

GH: One last question. You said recently, “We should be modest about what we actually know.” Do you have any feeling of disappointment about progress we’ve made in investing. If I were a surgeon or a pianist, after 35 years, I’d be very good.

BM: I think the reason we have not made much progress is that it is probably one of the most overpaid professions there is. It’s an inefficiency, with investment professionals paid regardless of the results. I’ve been an educator, and I just try my best in everything I do. I went to Wealthfront because I like the idea of doing good for humanity and I get paid in stock and I might do well financially at the same time. The real problem with us making enough progress in our industry is the misaligned incentives. But now, at least there’s a lot of competition in ETFs and fees have been driven down to close to zero.

David Graham
June 03, 2013

I agree with Scott. What is important to the client matching or beating an index or achieving a result consistent with investment outcomes. The fact is portfolios are rarely static so the outcome of an index can be irrelevant. For example, cash flows add sequencing risk to the equation. Moreover, given that clients generally feel loses more sharply than gains (Kanneman et al.) it is likely a downturn in a market is going to have a greater chance of inducing a client to bail out of an asset or asset class at exactly the wrong time. From our perspective our clients generally prefer to sacrifice some market upside if it can help mitigate downside swings. Of course this varies from client to client as these things need to be personalised. You may argue that this is purely an asset allocation decision. I disagree. As a case in point, I am reluctant to recommend index exposures to fixed interest assets at this time as it is obvious that the greater risk is tilted to the downside (from a price perspective) in this asset class. Given the lengthening of duration in global bond markets in recent years the impact of higher rates in the future will provide a nasty surprise to investors. I can maintain exposure to this asset class but reduce risk by engaging active managers with a mandate to manage duration.

There are a number of excellent active managers out there. You just need to do your research.These managers tend to invest in companies, not markets. This is the essence of investing. Indexing may suit certain investors who want to maximise market returns, but it is not for everybody. If you have neither the time or inclination to research and construct a portfolio that includes active managers, so be it. However this choice should not be used to dismiss active management outright or belittle the abilities of individuals through broad generalisations based on the specious research of vested interests.

Scott Barlow
June 03, 2013

Alun your firm, Rice Warner published a study in 2006 that tracked the "value-added" of the six largest asset consultants in Australia. (Implemented Consultants: Myth & Reality" February 2006). The broad conclusion of the study was that "...the commonly held view that asset consultants add value primarily through manager selection is, at least in some cases, simply not true."

The study discovered that the asset consultants with all their research, experience, global reach, skills, and their ability to attract analytical talent...were unable to add value from their manager selection abilites. It's a striking conclusion given this is supposed to be the "bread and butter" of these firms and is marketed to financial planners as their core competence.

My colleagues and I extended the study and we continue to track the results and I can report that 12-years of data later...none of the asset consultants have added any value in excess of the retail fee hurdle.

I believe the reason this subtraction of value occurs is because the strategic asset allocation portfolio construction approach (universally and unquestioningly applied by all the major asset consultants) contains a raft of performance damaging constraints that make it impossible for skilled managers to deliver value in excess of the retail fee hurdle. It's not because investment managers are unskilled or unmotivated.

One example of a 'constraint' that inhibits returns is the 'rule' that investments must fit into a pre-defined “class” (e.g. Australian Equities, International Equities, Listed Property, Fixed interest & Cash). Under this rule, the primary consideration behind the investment selection is to match the performance of each class with that of its broad market index (benchmark). Thus, investments that don?t fit into a class are often given a meaningless allocation, or are ignored.

I could go on and on with examples...but stack enough of them together and the portfolio ends up bogged down trying to meet multiple objectives (peer risk, benchmark risk, brand risk, decision risk....) and it's little wonder it can't deliver returns in excess of the fees and the 'cheap' alternatives available to investors. It's a shame and disgrace because ordinary retail investors shouldn't be expected to be aware of this awful feature of SAA portfolios - they pay their advisers to be aware and yet most are not.

As these quotes below reveal, our industry leaders are definitely aware of it:

“The strategic asset allocation (SAA) model used by many investment funds is fundamentally flawed. The approach must change. The assumptions we make are wrong. There are a large number of constraints in SAA.” – Greg Cooper, Chief Executive, Schroder Investment Management Australia

“Strategic Asset Allocation should be abandoned....because it is flawed to its core, always has been, and would never have gained credibility amongst investment industry participants if they had not been so easily seduced by the ‘efficient market’ view of the world in the 1980s and 1990s.” – Dominic McCormick, Chief Investment Officer, Select Asset Management.

“We believe the standard investment process employed by most Australian superannuation funds needs to evolve to reflect the current market environment and the fact that the process is failing to deliver investment returns that meet members’ needs.” - Sean Henaghan, Head of Multi-Manager & Investment Solutions, AMP Capital.

It's not that fees are too high, it's that returns are dragged down by the constraints. Other methods - risk targeting for example - easily beat the fee hurdles, delivering genuine value to investors worth paying for.

Our industry isn't useless, but it certainly needs to evolve away from the wholly discredited "asset allocation" approach if investors are to see the "value" of investment advice.

Alun Stevens
June 03, 2013

Jamie, I agree that there are significant advantages to holding equities directly versus via a managed fund (index or active). It is clearly impossible for a personal portfolio to fully match an index, but, because of the structure of the Australian market, one can do a fairly good job for the major indexes with a moderate number of shares should this be what you want to do.

I personally appreciate the benefits of direct holdings and only use managed funds (indexed) where I can't get proper spread via direct holdings (eg overseas).

Jamie Forster
June 03, 2013

I think that the discussion is less about active vs passive and more about direct vs unitised, particularly in relation to liquid assets.

If we accept that a passive manager will generally outperform an active manager after fees and possibly taxes, it is also accurate to say that, all else being equal, a direct portfolio will outperform a unitised portfolio for any given individual due to the ability to manage tax particularly CGT and corporate actions and to exploit the relative benefits of capital gains vs dividends for different marginal tax rates.

As it is not practical to construct an index-weighted portfolio of direct equities, then active management must be used.

It is my opinion that the tax benefits of investing directly out-weigh the additional fees for active management.


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