Legends Of Indexing: Burton Malkiel

December 15, 2014

'Random Walk' author talks about what has changed in the 40 years since its publication.

This is the third in a series of interviews with some of the most influential people in the field of indexing and index-based investment. The interviews are also published in the November/December 2014 issue of the Journal of Indexes.

Along with John Bogle, Princeton professor Burton Malkiel is one of the key figures in the index fund origin story. His best-selling book, "A Random Walk Down Wall Street," was first published in 1973, preceding the creation of the Vanguard 500 Index Fund by a few years, and really brought the efficient market hypothesis within grasp of the average investor. The 11th edition is set to hit bookstores early in 2015. Unsurprisingly, Malkiel served on Vanguard's board of directors for nearly three decades.

What in your outlook has changed since you wrote the first edition of "A Random Walk Down Wall Street"?

The basic message has not changed; that is that investors would be much better off if they used broad-based index funds as instruments for their investments. In fact, that has, frankly, become even stronger in my view than it was in 1973 when index funds weren't available for the public. One of the things I do for each new edition is ask whether the advice was correct, and I feel even more strongly today than I did when I first wrote the book.

Now, what has changed is the investing environment from when the first edition was published. For one thing, you couldn't buy index funds. There were no money funds. The whole landscape of investing has changed. The expense ratios were much higher. You didn't have the ETFs. Not only do you have index funds now, but you have ETFs, and basically you can go and buy the market at very close to a zero expense ratio.

There is much more material on international markets, and in particular on emerging markets. Emerging markets are now responsible for about a half of the world's GDP. They are growing much more rapidly than developed markets.

I have become increasingly worried about bond investing in the developed markets. We are living through an era that has been called a financial repression, where the United States, Europe and Japan—all of these nations—have big budget deficits and large ratios of debt to GDP. Financial repression is the government saying, "We've got to finance the deficits and the debt. We'll keep interest rates at extraordinarily low levels, and at levels that are generally below the rate of inflation, so that bonds are likely to give you a negative real (after inflation) rate of return, even if interest rates don't rise."

Short-term rates are zero in the United States. Even the 10-year Treasury is less than 1 percent in Germany and Japan. Financial repression works to solve your deficit and debt problem, but it works on the backs of the bondholders.

In the new edition, there is a lot of discussion about what do you do in this environment, and there is a fair amount of discussion concerning two strategies. One is to be far more international than you were. Our 10-year Treasury is 2.3 percent. Mexico's 10-year Treasury is close to 6 percent, and Mexico has a lower debt-to-GDP ratio than the United States. Mexico's fiscal finances are, if anything, in better shape than those of the U.S. The inflation is also reasonably moderate in Mexico—it's slightly higher than in the United States. Look at some of the foreign bond markets, including emerging markets, or emerging market sovereign debt specifically, because a lot of the emerging markets are in actually quite good fiscal shape.

The second thing—which has become increasingly popular, so this isn't quite as good as when I first started talking about it—is a stock-substitution strategy. Let's say we have a conservative investor, somebody in retirement who needs income and wants to be very conservative. The standard advice was you want a big bond portfolio, and as I've said, I am worried about that now.

Think of two instruments. One is an AT&T bond of moderate duration that would have a yield of something under 4 percent. Then let's look at AT&T common stock. Now I know stocks are riskier than bonds, but AT&T common stock has a dividend yield of somewhere around 5 percent, and the dividend for AT&T stock has been growing rather steadily over time. Now, I can't believe an investor in retirement isn't going to be better off with AT&T stock than AT&T bonds.

Admittedly, stocks are riskier than bonds, but I think bonds at these interest rates are particularly risky, because you could take some really bad capital losses in bonds when interest rates start to go up. A so-called dividend substitution strategy of substituting some relatively safe dividend growth stocks for bonds, particularly for government bonds, seems to me to be a reasonable strategy.

The summary answer to your question is nothing has changed, in the sense that I want to be an indexer and I feel even more strongly about it, but all of the instruments have changed.

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