Malkiel: Ignore China At Your Own Peril

September 18, 2013

The indexing legend sees huge opportunity in China and wishes Fed Chairman Bernanke would stay on for another term.


Burton Malkiel, the author of the seminal book on indexing, “A Random Walk Down Wall Street,” is more convinced than ever of the simple truth that a properly diversified portfolio of cheap index funds like ETFs gives investors the best possible chance to succeed. His involvement as a chief investment officer at ultra-cheap advisory firms like Wealthfront and Rebalance IRA signal that investors can now reap the benefits of cheaper financial advice as well.

The Princeton economics professor and advisor to China-focused index firm AlphaShares also told IndexUniverse Managing Editor Olly Ludwig he thinks the Federal Reserve under Ben Bernanke has done a fine job of steering the economy out of the financial crisis, and he reminded investors that the pullback in Chinese asset prices has created an upside opportunity the likes of which hasn’t been seen in years. What are your latest thoughts about the world of indexing?

Malkiel: Broad-based indexing has become more and more accepted in the financial community. It certainly was thought of as nutty at the very beginning. But it’s become more and more accepted because in fact, in period after period, low-cost, passively managed portfolios seem to consistently beat the typical active manager.

Every three or four years, when I do a new edition of my “Random Walk” book, I always look and say, “OK, how did it work in the last period?” And the general finding is that one-third of active managers generally beat the index in any particular period. And there’s very little, if any, consistency in that the one-third that win in one period aren’t the same one-third that win in the next period.

Secondly, the innovation of the exchange-traded fund has, I think, been very important, because the flows into the ETFs have been very, very large, so it’s all part of the reduction in fees.

And one of the reasons that indexing works is that it is low cost and has low fees. And with the advent of the ETFs and an enormous amount of competition, fees have been coming down—both for mutual funds and for ETFs—and I think that this has opened up the world of indexing to more and more people. Does any of the product development in ETFs bother you?

Malkiel: What I don’t like—and here I’m probably absolutely in the same camp as Jack Bogle—is the exotic products, which, for example, give you three times the upside of the S&P. These are products that are simply designed for speculation, not for investing. I don’t also believe that anyone can really time the market

So those are not things I like. And they don’t even do what they’re supposed to do. In other words, they’ll do it for one day, but you don’t buy that, put it away and, “Gee, the S&P was up 10 percent, was I up 30 percent?” It doesn’t work Let’s talk about the economy for a moment. How do you rate the Bernanke Fed?

Malkiel: I really believe that Ben has done a superb job. People often ask me, “Who is your choice to be the next Fed chairman?” and I usually answer that by saying, “Frankly, if it were my choice, and I were in the shoes of President Obama, I’d get down on my knees and beg Ben to continue.” I’m a big Bernanke supporter.

Given what was happening on the fiscal front, I think it was the Federal Reserve that deserves the lion’s share of the credit for having basically saved us from what could have been a Great Depression.


Malkiel (cont'd.): I think the Fed has been responsible for the fact that housing has turned around, and the private sector is doing as well as it is. A lot of people say that all of this didn’t work. I think it’s worked remarkably well.

Now, do I think fiscal policy’s been fine? I don’t. The main criticism I would have of fiscal policy is that we’ve really done nothing about the long-run fiscal problem, which is the huge changes in demography that are going to mean entitlement programs become more and more unfeasible. The fact that we won’t even talk about the things that are easy to fix, like Social Security—you could fix it by snapping your fingers—and the fact that we haven’t done the long-run entitlement programs is, I think, a real black eye for fiscal policy.

But as far as I’m concerned, the Federal Reserve has basically been our savior in terms of having the U.S. economy do as well as it’s done. Are you optimistic that the Fed is going to continue to extricate the economy from the perilous straits that it was in, the so-called tapering and the overall working down of the balance sheet?

Malkiel: I’m generally optimistic. I’m not one of these people who says there’s going to be a disaster. I think we’ll have a moderate tapering. I would frankly be surprised if it didn’t happen right away, if not this month. I think it will happen, and as the near-term fiscal drag gets a little less, I think that’ll be just fine. I think the economy will do well in 2014, despite the fact that the Fed will begin a tapering program.

Am I optimistic? Yes, I am. Let’s move to subjects that are near and dear to you. First of all, China. It’s beginning to transition. How’s this new regime going to handle the transition? What is your general view of that country right now and its next phase of development?

Malkiel: There’s no question about the fact that there is a necessary structural change in the Chinese economy. They have relied upon two pillars for their growth: exports and investment. You can’t continue to have the export-led growth proceed the same way. For one thing, some of their markets—like Europe, which is one of their main markets—are not in great economic shape. And while I think Europe will do a little better next year, Europe is still going to be weak. It just can’t be the same export-driven expansion that we’ve seen before.

And similarly, with investment, there’s excess capacity in some industries, such as real estate. There’s just no question about the fact that the structure of the economy is going to have to change.

Now, what is, for me, very positive, and I think, not appreciated to the extent that it should be, is that consumption is only about a third of GDP. And there’s no reason in the world why consumption couldn’t be 50 percent of GDP, or even more than that. It’s 70 percent of GDP in the United States.

So I think you’re going to see a change in the composition growth of the economy toward one where there is more consumption relative to investment and export and net exports.

Also, the growth can’t stay at 10 percent year. It’s just mathematically not possible to keep this up when you’ve become a really large economy. I’m not saying that this change isn’t going to be tricky, but I think the Chinese government will be able to help engineer this change.

I think that there’s far too much pessimism about China than there should be. And growth may slow down to 7 percent or even 6 percent, but China is not going to crash and burn. Quite the contrary: It’s going to continue to be, among the large economies of the world, the one that has the highest growth rate. How would you prepare investors in terms of expectations as to the time it might take for the government to effectively transition from that high-export model to an economy where there’s much more a more sizable consumption component?

Malkiel: It’s happening as we speak. Consumption is growing faster than GDP. And exports have not given China the kick that they did in the past. And while I’m not sure you can completely trust any of the figures you see, they certainly are reporting growth rates that are in the 7’s as opposed to the 9’s.

China’s the only country in the world where growth goes down from 9.5 percent to 7 percent or even 6.5 percent and everyone throws up their hands and says, “Oh my god, China is crashing!” We should have growth rate like that in the United States! You’re saying one needs to look at what’s going on now?

Malkiel: Yes. I just think there’s far too much pessimism.

Now, the other reason that I’m optimistic—you asked what investors ought to do—is that valuations matter. And China is about as cheap in terms of valuations as I’ve seen it in the years I’ve been following it, in that we’re talking about Chinese equities that are around 10 times earnings. So, expected returns are now quite sizable and investors should take notice?

Malkiel: I think so. Let’s talk about Wealthfront, one of your latest projects. It would appear from the cursory look I’ve had at the numbers that things are going well there.

Malkiel: Things are going extremely well there. I just actually saw the figures—they have $350 million under management. Give me a sense of the rate of growth. The last time we spoke about this in any detail, I believe the AUM was probably about $100 million; this was less than a year ago. When did this launch; about a year ago, maybe?

Malkiel: The other company I’m associated with is Rebalance IRA, which is also doing well.

And I’m just very excited about this, because I think investing is very uncertain; there are a lot of things we don’t know about. But the only thing about investing I’m absolutely certain about is—and I think that all of us who work in the investment area, who write about it, ought to be very modest about what we know and don’t know—the lower the fee I pay to the purveyor of the investment service, the more there’s going to be for me.

The beauty of Wealthfront is, we’re talking about an overall wrap fee of 25 basis points for managing a portfolio, and within that portfolio, it’s all done with index funds, and the lowest-cost index funds we can find. This may be one of the first times in the history of the advisory business where the fee pressure is extended to the actual advisors as well as to the products.

Malkiel: Exactly. And I think this is just in its infancy. I anticipate that just as indexing created a revolution in terms of portfolio management, that this is the beginning of a revolution in terms of investment advisory fees.



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