By Douglas Appell
Thirty-two years and another seven editions after first suggesting that a monkey throwing darts at stock listings could match a professional money manager, Mr. Malkiel insists his central thesis — that investors can do better in low-fee, low-turnover index funds than in actively managed funds — remains rock solid. On the occasion of his retirement, after 30 years on the board of the Vanguard Group, the Princeton professor discussed what readers can look forward to in the ninth edition.
Two years ago, Vanguard raised its retirement age to 72 in order to keep you on the board. This time around? They've done it once, and I think that was fine. I am staying on the Vanguard Europe board, which doesn't have a retirement age. So my association with Vanguard will continue.
In the 8th edition of your famous book, you say your argument in favor of index funds has met all challenges in the past 30 years. I think the basic thesis has held up very, very well. Index funds have outperformed the median actively managed equity fund during that period by more than 200 basis points a year.
What's next? I'm going to be working next year on the ninth edition. I'm trying to put a new chapter in on behavioral finance, which is the new "new thing" in the academic world. Some of the lessons that come out of behavioral finance are very useful, but they won't change the basic thesis. For example, there's "status quo bias": When you tell people where you work "We now have a 401(k) plan, would you like to sign up," a small fraction signs up. If instead you tell them "We have a 401(k) plan. It's not mandatory but you're signed up to it, and you'll have to tell us if you don't want it," then 85% to 90% sign up. When you think of our country's low savings rate and about how the boomers are going to finance their retirement, you realize that is a useful lesson.
But can behavioral finance produce market-beating returns? To the extent that behavioralists say you can use this to make extra money, that I don't buy at all. There's an old joke about the professor of finance who believes in efficient markets. He's walking along with his graduate student, who sees a $100 bill on the ground and starts to bend down. The professor says, "Don't bend down … If it were really a $100 bill, it wouldn't be there." It's possible markets sometimes will get things wrong; there could be some arbitrage opportunities, but they sure won't be there long. There are just too many smart people out there looking for them. So essentially, my view is that markets do go nuts sometimes — in the eighth edition I called the Internet bubble the biggest bubble of all time — but it wasn't an arbitrage opportunity where you could easily pick up the $100 bills.
But doesn't the idea that market players make predictable mistakes challenge the efficient market theory? There are two ways you can think of efficient markets: One way to say it is, the price is always right; the other way you can put it is, there are no $100 bills on the ground. I put it the second way. OK, sometimes things go nuts, but you only know after the fact how nuts they were. When Google went from $87 to $200 dollars, a lot of behavioralists said to me: "Nuts, see, this is exactly what we're talking about, this is crazy." But what if they'd sold Google short? (The stock is now trading above $270.)
Is indexing already a mature idea, in terms of the market's appetite? Maybe 25% to a third of institutional money is indexed today. Retail is probably about 10%. Part of the purpose of my book is to make individual investors more efficient. I think individuals are doing dumb things, moving from one fund to another. To that extent, is the market efficient? No, and individual investors aren't. If there were no active managers, the market wouldn't be efficient, but with so few indexing now, that's not an issue. I'm open enough to say, at the very least, index the broad core of your portfolio. If you want to have fun around the edges, fine. And you can do that with less risk if you've got the core of the portfolio indexed. In my own retirement accounts, I don't even 100% index, but I put well over 50% in index funds. Playing the market is fun!
Could the shift from defined benefit plans to defined contribution plans tilt the market more toward active management? I would hope not. Presumably, it's professionals who are going to present the list of options to the 401(k) participants. I could see (the DC market) moving toward some prepackaged funds, some lifecycle funds that have a larger proportion of low-cost index funds ... The other reason that this thesis might be even more important in the future is if, and it's my view, we are in a single-digit world where equity returns are maybe 7%, 200 basis points in fees are going to kill you. You know, the way that compounds is after 25 years, you've lost over half your money to expenses.
Are there any signs that institutional investors are straying from the index fund path? They might be. You know, I'm very suspicious of the whole hedge fund phenomenon. I think some of the hedge funds had very good returns in the early years, but I don't think with a trillion dollars in this market now that you can sustain those kinds of fees. I think there'll be a lot of disappointed people..
But don't hedge funds have a role to play in making markets efficient? Yes, they do. For example, event-driven hedge funds make markets more efficient. It brings prices together and it makes money, most of the time. The issue for investors is, isn't it a much better deal for the hedge fund manager than it is for the investor? And once you've got a trillion dollars in there and it's leveraged, are there going to be enough of those opportunities or are you going to have too much money chasing too few opportunities? So am I telling you there ought to be no hedge funds? No; I'm just saying there ain't no free lunch out there. It may just be that the reasonable thing to say is, "We're just going to have to set our sights lower." Or, if you've got a DB plan, you've got to put more money in it.
What do you think about enhanced indexing? My guess is that in the future we'll see not only a growth in indexing but in enhanced indexing: still low risk, a little bit higher expense, but not as high as full active (management), and at least a chance of doing better than the index — because I think it's human nature that you can't really tell anybody that has an interest in the stock market that there's just no way to beat the market; it's like Santa Claus doesn't exist. So I see a good future for enhanced indexing.
But would that be a regrettable development from your perspective? There are some purists who would say, "Oh no, that's just horrible, that's an oxymoron," but I don't. My work makes very clear two things: the lower the expense ratio, the better the returns; the lower the turnover, the better the returns. In other words, somewhat less active, somewhat lower expense; I think it is such a major step in the right direction that I applaud it.
Did anyone ever try to get you to manage money? I've done a lot of board work, and I really didn't want to get into the situation of competing with people on whose boards I sat. Were I to do it, I'd probably go in the direction of enhanced indexing, as opposed to the full active route.