The Professor Who Was Right About Index Funds All Along
Burton Malkiel has been saying the same thing about investing for more than 40 years. What’s new is that a big chunk of the financial industry now admits he was right all along.
In 1973, Malkiel, a Princeton professor, published the first version of his investment guide, A Random Walk Down Wall Street. He wrote that “a blindfolded monkey throwing darts at the stock listings could select a portfolio that would do just as well as one selected by the experts.” Since most investors can’t beat the market average over time, he argued, they’d be better off in some kind of low-fee fund that simply held all of the stocks on a widely followed index. Problem was, no such retail fund existed.
When a new fund company called Vanguard finally rolled out the first index mutual fund three years later, Ned Johnson, then the head of Fidelity Investments, spoke for most money managers when he told the Boston Globe, “I can’t believe that the great mass of investors are going to be satisfied with an ultimate goal of just achieving average returns.”
Things changed ... slowly, and then all at once. That first fund, the S&P 500-mimicking Vanguard 500 Index grew to a respectable $3 billion in assets in its first 20 years. But when it turned 40 years old on Aug. 31, it had more than $200 billion in assets, making it the third largest mutual fund, behind two other Vanguard index funds. From the end of 2007 through 2015—that is, since the financial crisis—domestic equity index funds saw a net inflow of investor money as active stockpickers grappled with outflows. About 34 percent of all fund assets are now in index trackers. Fidelity, though still a believer in the idea that managers can beat the markets, now advertises how inexpensive its own index funds are.
“This was an idea that was thought of as heresy or utter stupidity and now many realize it was the right way to go,” says Malkiel, in an interview at Princeton, where he is now a professor emeritus of economics. Weak performance has made life hard for managers who still actively pick stocks: According to the latest data from S&P Global, fewer than 15 percent of active large-cap stock funds beat the market index over the past 10 years. Index funds reliably deliver the market’s return minus yearly fees that may be 0.10 percent of assets or less, compared with stock funds’ average of 1.3 percent.
Malkiel, 84, is now chief investment officer at Wealthfront, a Silicon Valley startup that’s become one of the leading robo-advisers—firms that use index funds to build automated investment plans for a fraction of the fees charged by traditional advisers. Just as index funds brought down the cost of investing, robo-advisers will bring down the cost of advice, says Malkiel, who spent 27 years on the Vanguard board. “The one thing I know is that the less I pay the purveyor, the more there will be left for me,” he said.
Malkiel grew up without money in the Roxbury neighborhood of Boston during the Depression, and went to Wall Street after stints at Harvard and the Harvard Business School. He rejected a career in academia, at first, because he was tired of being poor.
On Wall Street, he noticed that if you followed the recommendations of the bright, talented stockpickers he worked with, you rarely made money. He also saw that brokers recommended to customers the funds they were paid the most to promote. Malkiel left Wall Street for Princeton in 1960 but never left the business world behind. He estimates he has served on the boards of 30 different organizations over the years, including two biotech companies where he still holds a seat.
Jack Bogle, founder of Vanguard, says Malkiel “was the best director we have ever had.” Robert Arnott, co-founder of California investment strategist Research Affiliates, recruited Malkiel to serve on his advisory panel. “We wanted someone who is a critic of our ideas, who was willing to be blunt-spoken,” says Arnott. He got his wish. Arnott is a proponent of so-called smart beta—a variation on indexing that Arnott and others think will lead to better performance. Malkiel calls smart beta “smart marketing.”
Adam Nash, chief executive officer of Wealthfront, says Malkiel played a critical role in creating one of the firm’s most successful products, a system for maximizing the tax losses investors can claim in a given year. Malkiel says computers can do that job better than humans.
Automated advice is still a relatively tiny business, but Malkiel thinks that, as with indexing, the services will win over the skeptics. “You hear people say, ‘Do you want a robot managing your money?’ ” he says. “Believe me, there are plenty of smart people behind the robots.”
A Random Walk has sold more than 1.5 million copies in 11 editions. Even professional stockpickers concede that they have to do a better job if they are going to hang on to assets. An investment management company “has to do something that a computer can’t easily replicate, and it has to justify its fee through higher return or lower risk,” William Nygren, manager of the $15 billion Oakmark Fund, wrote in a June report to shareholders.
Malkiel is convinced most managers can’t do that. The bet has gone his way for four decades running.
The bottom line: Once an oddity, index funds are now one-third of fund assets. Burton Malkiel was one of the first to see it coming.