Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

For decades, Burton Malkiel has been a leading advocate of the efficient market hypothesis and its logical extension, the low-cost, passive approach to investing -- as outlined in his bestselling book, "A Random Walk Down Wall Street." Dr. Malkiel is a Princeton economist and Chief Investment Officer of a robo-adviser, Wealthfront.

I had the opportunity to chat with Dr. Malkiel recently about smart beta, his Wealthfront portfolios, and how investors should think about rock-bottom interest rates.  

You’ve been a vocal critic of smart beta.

My sense is that the factors behind smart beta are not dependable. Where they may work, they undoubtedly involve more risk. When I have examined the smart beta ETFs that have been in existence, I did not find that – after expenses – they have given investors a better risk-reward tradeoff.

I therefore conclude that it’s probably more that smart beta gives managers an opportunity to charge higher fees, and this is not necessarily good for investors. I remain convinced that a straight capitalization-weighted, broad-based index fund is still the best way for individuals to invest.

What if you could buy a U.S. large cap value ETF for the same low 0.05 percent expense ratio as a Vanguard S&P 500 ETF?

It would clearly be a much better product for the investor and I would certainly like that a lot better. If you were convinced that value was the best way to invest and you could get it for five basis points, I certainly wouldn’t object to anyone buying it.

So, yep, you could do it if you wanted at a low fee, but just be very careful and don’t expect any consistency from smart beta factors even though historically you can find periods where they’ve worked.

Is there a benefit to diversifying across smart beta styles?

If you want a portfolio that has a diversified number of styles, that is the market cap portfolio.

According to MSCI, emerging markets represent 10 percent of the world's overall market cap, but your Wealthfront portfolios allocate 18 percent of stocks to emerging markets. Why the deviation from market cap?

It’s not a deviation from the market cap portfolio. EM is about – and this is float adjusted – 17 percent of the world market cap. And in fact, to the extent that today institutional investors as a group hold about 4 percent of their portfolio in EM, it’s a reflection of the home country bias. Wealthfront is closer to market cap weighting, which is actually completely consistent with an indexing view.

Also, the Shiller P/E is about 26 in the U.S., which is well above average. It’s about nine for emerging markets, which is well below average. It’s also the case that emerging markets are the cheapest markets in the world.

Not Dependable?
Value has failed to keep up with the broad market over the last five years.
SOURCE: Bloomberg

That sounds like a value strategy.

We use portfolio theory to put together a whole portfolio, and what you need to do is put expected returns into the Markowitz equation. One of the ways that we try to put the expected returns in is looking at things like the Shiller P/E ratios.

Many investors worry about what low interest rates mean for expected bond returns. Are they right to worry and what if anything should they do about it?

I’m a big indexer and in general I would believe in bond market indexing. But there’s one problem I feel with the bond market index in the U.S. Since the government now guarantees all the mortgage bonds, if you look at a U.S. bond market index fund, it’s about two-thirds government securities.

For better or worse, the central banks in the U.S. and all over the world have embarked on a policy of pushing interest rates down. It’s an era of financial repression, and I worry a lot about the bond market. If interest rates rise, I think people are going to be in for a lot of trouble in the bond market.

What we do at Wealthfront is use more corporates rather than governments because the corporate spread is about where it’s been historically. And we even use an “equity substitution strategy” where we’ll take a small piece of that “safer” part of the portfolio and put it into stocks like AT&T that have a 5 percent dividend yield, and where the dividend has been growing over time.

So I think what this era of financial repression means for investors is the old easy way of doing it – of just buying an index fund – may not work as well as it has in the past.

Go Your Own Way
Wealthfront's stock allocations depart from the MSCI ACWI Index, a free-float adjusted market capitalization weighted index.
SOURCES: Wealthfront, Bloomberg

Are high-dividend stocks more risky than bonds?

Traditionally, yes. If you look in terms of traditional risk measures, they are more risky, but in my view investors are going to be much better off.

You famously wrote that a blindfolded chimpanzee could select a portfolio that would do as well as any expert. How do you reconcile that view with Buffett’s long-standing success as a stock picker?

Warren Buffett has in his will instructed his widow to invest in index funds, which means that’s what Warren Buffett would do.

How do you invest your money?

I invest my own money largely in index funds.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in New York at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Timothy L. O'Brien at tobrien46@bloomberg.net