Malkiel: No Free Lunch With ‘Smart Beta’

March 16, 2015

Exchange-traded funds are the next logical step of the indexing revolution, and, as such, they get more prominent treatment in the latest edition of the classic book on indexing, “A Random Walk Down Wall Street.” Burton Malkiel, the Princeton economics professor who first published the book in 1973, is about as enthusiastic a proponent of ETFs as you’ll find anywhere, and the 11th edition of a “Random Walk” reflects that enthusiasm.

They’re cheap and efficient, opening up the world of investing to anybody who has earned the privilege of having investable assets, Malkiel told in a recent interview. Still, he made plain that investors need to be discerning when venturing beyond the broad market strategies he first championed four decades ago. Specifically, Malkiel said investors need to truly understand what “smart beta” is, and he also cautioned against more speculative ETFs such as those that serve up double or even triple exposure to their underlying indexes. So, the 11th edition of “Random Walk” is out and you’ve included a lot more about ETFs.

Burton Malkiel: Yes, there is more on ETFs. Just to give you one example, in earlier editions, there was an appendix called "The Random Walker's Address Book," which basically only included mutual funds. It gave some names of mutual fund companies and their 800 numbers, and so forth. There's still information on where you can find out about mutual funds, but there are also listings of equivalent ETFs.

There's also a new chapter where I am perhaps somewhat more skeptical about a number of the newer ETFs that have come up. There’s also a whole new chapter on smart beta. I think some of the smart-beta ETFs have done OK, but more of them haven't. I think sometimes they're mis-sold.

And the very clear feeling that I have is that I still very much more favor the plain-vanilla ETFs over the fancier ones. The VTIs [Vanguard Total Stock Market ETF (VTI | A-100)] of the world, if you will, the total market types of index funds?

Malkiel: Yes, exactly right. Let's talk about “smart beta” for just a moment. You mentioned some seem to work well and many do not. How do you separate the wheat from the chaff?

I would say, first of all, that they are often mis-sold. To give you an idea, that so-called fundamental indexing, the RAFI ETF, is sold as a way in which you can avoid the overpriced stocks in the market. And that simply isn't true.

Rob Arnott's argument against what I would call pure-vanilla indexing is that if a stock goes up and gets overpriced, it'll have too big a weight in the index and you'll be holding too much in overpriced stocks. I think that's basically wrong. But the so-called Cisco Effect that occurred 15 years ago with the dot-com bubble really was a problem for cap-weighted indexes, wasn’t it?

Malkiel: There were times when, during the Internet bubble, you did have a big weight in some high-tech stocks, and that was the time when value outperformed. One of the things smart beta does do is emphasize value, which is actually implicitly what Arnott does. And it works sometimes and it doesn't work other times.

Over the whole period, Arnott has not outperformed. He has tilted a portfolio in some particular directions, and his alpha is exactly zero. That's one of the things I point out in the book. In this 11th edition?

Malkiel: Yes, in the 11th edition. Was that a beautiful time to be in value stocks? Absolutely. But value has underperformed the last two or three years. There are cycles in these kinds of things. It's not that you've got some method where you're going to be better all the time.

The other thing about that particular implementation of smart beta is, the one period where RAFI really outperformed, was actually coming out of the financial crisis. And in 2009, RAFI doubled the weight of bank stocks and had 15 percent of the portfolio in Citigroup and Bank of America.

Now, this was a period when, you may remember, we were thinking that the government might very well nationalize the banks. The banks were cheap, relative to book value, which is one of the things that Rob uses in his smart-beta implementation.

But holding a portfolio that had 15 percent in a couple of stocks that were teetering on the edge was a bet that worked. But don't tell me that that wasn't risky.

So, my other complaint about this is, to the extent that you can find things that worked, they only worked because you were taking on a portfolio that had considerably more risk than a general-market portfolio. You're saying it all looks very effective in the rearview mirror, but in fact with regard to banks, to use your example, there was an immense amount of uncertainty?

Malkiel: Right. Now, he took a risk and the risk worked. The banks didn't get nationalized. The stockholders didn't get zeroed out. And that was a period where he did outperform. In fact, it's the only period that he outperformed.

But don't tell me this was because he avoided overpriced stocks. He outperformed because he was taking on an enormous amount of risk. So any time you tilt, sometimes it's going to work; sometimes it isn't. Generally, if it works, you're getting paid for taking on risk.

Then my final complaint, and this really goes back to what I said of why I love ETFs, the low expense ratios, but the expense ratios for a lot of these smart-beta ETFs are four, five, six, 10 times the expense ratio of the plain-vanilla ETFs, which have been basically brought down to 4 and 5 basis points. When you’re looking at the whole plethora of smart-beta ETFs, they are very expensive.

And one of the things that I say in the 11th edition is that all of us who talk about markets need to be modest about what we know and don't know. But the one thing I'm absolutely sure about is that the lower the expense rate that I pay to the purveyor of the investment service or the manager of the fund, the more there's going to be for me. Any other things you emphasize in the book?

Malkiel: Yes, plain-vanilla funds. As far as I'm concerned, if I can buy a total stock market fund for 5 basis points, this is one of the greatest financial innovations of our time. I mean, we started off with index funds that, at the beginning, were probably 30, 40 basis points, which was less than active funds then.

But what the combination of the ETF and the discount broker has done is brought to the individual investor the most efficient possible way of investing. And ETFs should be used even more. They should be used in 401(k)s. And you're seeing it. You're seeing more and more money going into ETFs and indexing. Let’s talk about John Bogle and his critique of how ETFs are being overtraded to the detriment of investors.

Malkiel: Look, the two types of problems where I'm absolutely in agreement with Jack are you've got to be an investor, not a trader. You'll kill yourself if you're a trader. We know that when you're a trader, you put your money in when everyone's optimistic.

More money went into equity mutual funds during that bubble period than ever before. The money came out in late 2008 at the height of the financial crisis. So people will do absolutely the wrong thing. So that's one problem.

The other, which Jack has emphasized, is that some of the ETFs are nuts. Now, I don't think the smart-beta ones are nuts. I'm talking about the ones that will give you three times the upside of the S&P, which works only for one day.

Again the ETFs that are good are those broad-based great ETFs. Even if you don't agree with me about being skeptical about smart beta—if you're in retirement now and you want an ETF that is tilted toward high-dividend stocks because you can't get any money out of the bond market, I've got no objection to that. In fact, I even recommend it in the 11th edition. Now, if you were going to make a case for smart beta—saluting the credibility and insights of Fama and French and others, how do you do it?

Malkiel: Look, there is some evidence over long periods of time that value investing—buying stocks that are lower in price, with lower price-to-book ratios, and so forth—has done better. Your choice of value just now is no accident, right? When we talk about the factors, value is the one that’s most stable?

Malkiel: Of the factors that are used, the biggie is value. The other one is small-versus-large. Small has generally outperformed large. Now, it hasn't done it recently. I'm with Eugene Fama—if that continues, it's because you're being paid for taking on more risk. In other words, this isn't finding a way to outperform. This is a way of taking on more risk and getting paid for it.

But again, if you want to have a small-cap ETF, that's fine. The other is low volatility. We know the capital asset pricing model doesn't work. Low-vol stocks do as well as high-vol stocks. So there are low-volatility ETFs. They haven't done particularly well. And momentum is another factor.

My feeling about the factors is that they’re much less dependable than one should believe from the past empirical work. And the past is not always prologue. If you have a period like 1999, and growth is far overvalued relative to value, maybe a value tilt is something you would want to do. Do you want to do it today? I'm far less certain. I like to call it factor fatigue. When everybody and their brother piles in, you've got some underperformance coming right up, right?

Malkiel: Exactly. It doesn't work all the time. If it works, it tends to be a reward for risk. And smart beta's been oversold.




Find your next ETF

Reset All