Burton Malkiel's Index of Insights

The Random Walk guru offers his take on ETFs, annuities, and how investors should react to rising interest rates

Exchange-traded funds have proliferated over the past six years as investors have become more conscious of the need for diversified portfolios to protect themselves from exposure to specific stocks. According to a new report by Morgan Stanley (MS), 116 ETFs were issued in the first four months of this year, three-quarters of the number issued for all of 2006. ETFs achieve much of the same investment aims as mutual funds without the costly transaction fees.

The passive buy-and-hold technique common to index funds has proved over time to outperform the returns investors realize through actively managed mutual funds or individual stock picks, says Burton Malkiel, who has just come out with an updated, ninth edition of his book A Random Walk Down Wall Street. When it comes to ETFs, he prefers that they be broad-based, and he emphasizes that he likes ETFs because they are index funds.

He also made it clear that his advocacy of an index-fund strategy doesn't preclude setting up what he calls a "satellite portfolio" of actively managed funds or even individual stocks that enable investors to take bets on enhanced returns. This provides a way for investors to focus on a particular industry they think has better-than-average growth potential or to use the specific expertise of an active-fund manager.

Most important is that a satellite portfolio should have low to zero correlation with what's in your primary indexed holdings, as it reduces the risk of the whole portfolio.

BusinessWeek's David Bogoslaw met with Malkiel on the sidelines of a Barclays Global Investors seminar about ETFs June 12 in New York. Edited excerpts of their conversation follow:

Your view on ETFs is generally positive?

My take on ETFs is that if you have a certain amount of money and you're putting a lump sum into the stock or bond market, an ETF is a sensible way to do it. It's cheaper than a mutual fund because a mutual fund has to have a transfer agent to take care of all the people involved in a transaction [which makes for higher fees].

If you own an IRA and are in the habit of putting $200 a month into your IRA, it's better to go with a mutual fund because of the brokerage costs you pay every time to get into an ETF.

The one thing about which I am absolutely certain is that if I pay less in fees, there is going to be more for me.

What have you made current in the new edition of A Random Walk Down Wall Street?

While the basic message hasn't changed in that it says indexing is a smart way to approach investing, what's changed is the kind and number of instruments available to people. When I first wrote this book in 1973, there were no money-market funds, no municipal bonds, no 529 college savings plans.

As new instruments have become available and there are new opportunities for people to save on taxes, the book continues to ask: Was the [original] advice on index funds right? Are you better off by investing in them?

There are not a lot of ideas that have come out of the academy that work, and [indexing] is one that works!

Whatever new [investment instruments] that have come out, there are two big things that I've added to the ninth edition of the book: (1) a new chapter on behavioral finance [that highlights] lessons for the investor that are good and the lessons for people to be cautious about, and (2) a new chapter on investing for retirement, given there are a lot of baby boomers who will be retiring soon.

Speaking of retirement, what's the best way for retirees to minimize their capital loss if they find themselves taking money out of their portfolios during a downturn in the economy?

When you're taking money out of your portfolio during a down cycle, it's the opposite of dollar-cost averaging.

No. 1 is, should you annuitize some part of your retirement savings when it makes sense to do that? You could buy an annuity like a fixed-income [annuity] or an annuity that will [adjust for] the CPI. You don't want to annuitize everything, however, because you want some parts that are flexible. An investor would want that flexibility, for example, for an around-the-world trip if he learns he has an incurable disease and has only a couple years to live.

There does seem to be some evidence of negative correlation between bond and stock markets [over time]. If you had retired at the beginning of 1999 and wanted to take money out of your portfolio at the end of 1999, if in addition to dividend income you have to sell some assets, [you would have done well to sell some of your stocks] to make the distribution help in rebalancing your portfolio when the stock market is high.

In 2002, interest rates were down and bond prices were up, so you would take [cash] out of the bond market to help you in rebalancing your portfolio.

So it's advisable to have some part of your retirement portfolio in annuities and some part in a rebalancing strategy [between stocks and bonds].

Interest rates are going up now and the bond market is bad, so you take [your money] out of stocks. What you're always doing is trying to take money out of the best-performing asset class.

Why do you believe that price-to-earnings multiples for most U.S. stocks are compressed at this time?

In January, 2000 [at the top of the technology stock bubble], if a p-e multiple was normally 20 times, it went up to 30 or 40 times. Cisco (CSCO) was trading at more than 100 times earnings. [Valuations] went up even for companies that didn't have earnings yet. Clearly that was a bubble and the bubble burst. It seems that markets overreact. As the market adjusted, p-e's for growth stocks have come down and I'm suggesting that the market has overreacted the other way [to the downside]. Growing companies are now selling at p-e's for normal companies.

There's a value bias, and the value bias worked when we were coming out of the bubble, but today is different. I would never advocate investing only in growth, but I wouldn't deliberately make a bet on value today given how compressed the multiples are and may even be overcompressed.

In early 2000, only about 20% of the companies in the S&P 500-stock index had multiples within 20% of the S&P 500 multiple. Today, 55% to 60% of companies have multiples very close to the average. The difference [in valuation] between a growth stock and an average stock is not so great [as it used to be].

With many people convinced that the Fed is now leaning toward raising interest rates, there's likely to be more volatility in the markets. What are some ways for investors to protect themselves in this environment?

Buy and hold because there's no way for you to [know how to] play it. A month ago, people thought the whole subprime [lending crash] was going to derail the market and people were concerned about what was essentially no growth in the economy in the first quarter. Now the inflation news is not so good and the subprime thing has not spread into broad consumer [sectors]. It's not so smart to react to each of these things. You pay more taxes and you pay more fees when you do. My conclusion is you don't react.

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