Straight From The Source: Jonathan Clements

February 07, 2008 interviews The Wall Street Journal's Jonathan Clements. assistant editor Heather Bell recently spoke with Jonathan Clements, senior special writer for The Wall Street Journal, who writes the newspaper's widely read personal finance column, "Getting Going."

Index Universe (IU): What is your investment philosophy?

Clements: In essence, I think all investors should start by sitting down and asking themselves what mix of stocks and more-conservative investments they want to own, because that's going to be the principal driver of their portfolio's performance. And once they settle on that basic mix of stocks and more-conservative investments, they should devote all their energies to diversifying as best they can, reducing costs as much as they can and being as tax efficient as possible. If they do that, not only are they going to build a global portfolio, but also they'll inevitably end up investing in index funds.

IU: What type of investor are you writing for in your "Getting Going" column?

Clements: When I wrote my first column in October 1994, the mandate was to have a column geared toward ordinary investors, people who have $100, $500 or $1,000 to invest. That's continued to be the mandate. Over time, I think investors have become more sophisticated and the dialogue in the financial press has become more sophisticated, but the basic thrust of the column remains the same: trying to help the ordinary investor.

IU: Why are investors generally so bad at investing?

Clements: We know, thanks to neuroeconomics and behavioral finance, that investors make all kinds of mental mistakes. I think a key problem is that investors take what works in the rest of their lives and try to apply it to the financial markets. If you find a restaurant that's popular, it's likely to be good. If you find an investment that's popular, you're likely to lose money. If you work hard at your job and keep yourself busy in the office, you'll probably get promoted. If you work too hard at investing and you're too active in the financial markets, you'll probably lose your shirt. If you strive to win in the rest of your life, you'll likely get ahead. If you strive to win in the financial market, you'll probably end up losing. A lot of investing is counterintuitive.

IU: With the increased availability of information, is it easier for someone to be a successful investor now than it was two decades ago?

Clements: If you go back to the late 1980s, investors would ask questions like, "What's the best mutual fund to buy?" There was this relentless focus on buying the best stock or the best mutual fund. Today, investors are more sophisticated: They're asking questions like, "How do I build a great portfolio?" And that shift by investors is reflected in the information you see in the financial press. The financial press is much less likely to offer a string of hot stocks or hot mutual funds to buy, and they're much more likely to couch advice in terms of building portfolios.

At the same time, we've seen this evolution in the offerings from Wall Street. It's now possible for ordinary investors to build much more sophisticated portfolios than they could build 20 years ago. The problem is, not only do we have the tools to build much more sophisticated portfolios, but also we have more tools with which to shoot ourselves in the foot. For one set of investors, that new commodity ETF is a great way to diversify their portfolio. For another set of investors, that new commodity ETF is a great way to chase performance.

IU: How do you get the message across to people that indexing is the right choice?

Clements: There have always been a minority of investors who have been intensely interested in the financial markets and the related academic research, and those people have gravitated toward index funds. But that's the minority. Those are the people who buy investments, rather than having them sold to them.

What about the people who are sold investments? The arrival of ETFs has changed the story. Go back to the 1990s and you couldn't get a broker to sell an index fund. But now, thanks to the introduction of ETFs, brokers have a financial incentive to sell index funds. And the turnaround has been astonishing. Ten years ago, brokers would write me and would tout their abilities to beat the market and decry index funds as guaranteed mediocrity. Today, brokers are happily building portfolios of ETFs for their customers, and they can get compensated for doing so. It's amazing how the discourse among financial advisors has changed. That whole "beat the market" mentality has gone out the window because brokers can make money selling ETFs.

IU: So, because brokers now have a financial incentive, it's paved the way for a philosophical shift?

Clements: That is exactly what has happened. I can sit there and write clever articles about indexing until I'm blue in the face, but my articles are never going to have the impact that hundreds of thousands of brokers are going to have cold calling customers around the country. Now that you have a financial incentive for brokers to sell index funds, it's having a huge impact on the way people invest.

IU: Do you think indexing is the way to go in all cases? Do you think it's the best way to gain exposure to an asset class, or are there some asset classes where you should look at an active tilt to it?

Clements: If there's an asset class in which an index fund is available, my first inclination would be to buy the index fund. I know the argument is made that, in an inefficient market, an active manager can add value. But you have to think about why an inefficient market is inefficient. It's inefficient because it costs so much to trade and it costs so much to gather information. If the market really is inefficient because of those two factors, then indexing makes even more sense, because you're not going to incur the hefty investment costs from trading and from gathering information.

IU: Besides reversing broker attitudes about indexing, how have ETFs changed things?

Clements: There are two great things about ETFs. First, you separated the cost of management from the cost of distribution. That means that people don't have to go to one particular mutual fund company in order to get these index funds. Anybody who's able to sell investments can sell ETFs.

The second thing about ETFs that's revolutionary is the ease with which they can be introduced. You don't have a single firm responsible for distributing these funds, servicing shareholders and building up a critical mass of assets. We've seen these things introduced by not just the dozen, but 50 at a time. That means there's a lot of innovation going on in the ETF area. Thanks to ETFs, we can now tap into asset classes that index funds investors weren't previously able to tap into.

There has, of course, also been a slew of really stupid innovations. There are a lot of ETFs out there that I can't imagine anybody would want to own as part of a diversified portfolio. As you know, we're in the land-grab stage of the ETF revolution. Everybody is throwing ETFs out there, hoping to score a big win and gather a lot of assets. In the process, a lot of nutty ideas have been produced. Still, for the intelligent investor looking to build that globally diversified, low-cost portfolio, ETFs have been a bonanza.

IU: What are the negatives of launching so many ETFs covering obscure portions of the market?

Clements: There are really two worries about the foolish ETF concept. One, investors can now buy these narrowly sliced funds that aren't suitable for a well-diversified portfolio. They're highly volatile funds and investors could end up losing a lot of money.

The second issue is, how many of these ETFs are going to survive? One of the big advantages of ETFs is they should be highly tax efficient. But if you buy an ETF that doesn't gather enough assets and ends up getting liquidated, at that point the tax efficiency is over. We haven't seen many ETF liquidations so far. [Editor's Note: This interview was conducted before Claymore announced the closure of 11 funds.] But with all the funds that have been introduced in the recent years, you've got to presume that some won't survive.

IU: Do you think that ETFs could actually replace mutual funds? Jack Bogle, for one, does not seem too fond of them, despite the fact that they are index-based funds.

Clements: I understand Jack's concerns. There are a lot of stupid ETFs being introduced and a lot of people are trading these things like crazy. With an index fund, the idea is that you buy a broad slice of the market and you sit there quietly for years and years. There's a lot of nonsense going on in the ETF area. Nonetheless, there's also a lot of good stuff going on.

Will they eventually replace conventional index mutual funds? I think ETFs will likely grow to be larger than conventional index mutual funds, but for a lot of people, conventional index mutual fund will remain a much better investment option. Even if you're paying $5 a trade, it's still very costly to build a portfolio of ETFs if you're only investing $100 or $200 at a time. For the ordinary investor who is dollar-cost averaging into the market, ETF trading costs are really prohibitive, and that investor should be buying index mutual funds.

IU: What do you think about exchange-traded notes (ETNs)?

Clements: The tax issue aside, I think of ETNs in the same way I think of ETFs. They're offering investors a way to tap into different market segments. Yes, some ETNs are narrowly focused, but some of them are pretty broad, like the commodity ETNs that Barclays Capital introduced based on the broader-based commodity indexes. I'm, of course, aware that—in the case of the iPath funds—they're obligations of Barclays Bank. But unless you think Barclays is going under—which I don't—they seem to be basically the same as an ETF and should be thought of that way.

IU: Do you believe fundamental indexes are a better or worse option than capitalization-weighted indexes?

Clements: If you want to guarantee that you're going to outperform most actively managed funds in a particular market segment, you want to buy a market-cap-weighted index fund. If you buy anything that deviates from market-cap weighting, you are making a market bet. You're not replicating the market, so there's a risk you will fare worse than most active investors.

Fundamental indexing is basically just another way of value indexing. But I don't want to sound too dismissive. I think that fundamental indexing is a brilliant rearticulation of the value concept. I really like the notion that stocks have a fundamental value, that the market is noisy and thus that share prices will stray from those fundamental values. I think that's a great way to think about value investing. But in the end, fundamental indexing is a value tilt. It is a market bet that may not pan out. If you want to guarantee that you'll outperform most investors, you still need to be doing market-cap weighting.

IU: Is a recession a time when people should take another look at their portfolios to see where they're at with them?

Clements: My investment process is really very simple. You build that globally diversified portfolio. For every fund you own, you should have a target portfolio percentage. If you allocated 5% to emerging markets, the economy goes into a recession and emerging markets get creamed, then at some point you should step up to the plate and rebuild your position back up to 5%. If you set target portfolio percentages and you regularly rebalance, you'll find yourself buying low and selling high.

IU: Should investors be worried about the housing market and take it into account in their investment portfolios?

Clements: Everybody knows that the housing market is in rotten shape. That's not news. So presumably that's already pretty fully reflected in market prices. What you want to worry about is the stuff that's not known by the market. The problem is, we don't know what that is. News by definition is unknowable.

The message here is, "Stop trying to be so clever." If the market knows, it's already reflected in prices. If the market doesn't know, you sure aren't going to figure it out on your own.

IU: How important do you think international diversification is, and at what point do you have enough of it?

Clements: In the 1990s, I was saying that people should have 30% of their stock portfolio abroad, and that's the number I still use. Back in the 1990s, people would write to me and say 30% is way too much. Now, I hear from people who say 30% is way too little, and you should have half your money abroad. Clearly, there is a lot of performance chasing going on.

In the 1990s the U.S. market was a great place to be and foreign markets were not so good, so everybody wanted to be invested in the U.S. market. In the current decade, foreign stock markets have done far better than the U.S. market and everybody wants to be heavily invested abroad. But you can't buy past returns. What you get is the future.

I think a 30% allocation is probably about right. That will give you a decent amount of diversification, and it also fits with the liabilities that you're looking to fund. When you retire, you will be spending your money on the early bird special at U.S. restaurants, you'll be getting the blue rinse special from a U.S. hairdresser and you're going to go to bed at night in a U.S. nursing home. Most of your liabilities are going to be in U.S. dollars, so you probably want to have the bulk of your stock portfolio invested in U.S. stocks.

IU: Pensions are no longer something people can expect, and Social Security seems like it might be undergoing some major changes. How has the concept of retirement and retirement savings changed? 

Clements: I said earlier that I thought that ordinary investors had become more financially sophisticated. In truth, they've been pushed into this. The demise of the traditional company pension and the rise of 401(k) plans has compelled investors to become more knowledgeable about the financial markets.

I think the most interesting issue today is how to generate retirement income. Now that we've got the baby boom generation retiring, that issue is coming into sharp focus, and we're seeing a slew of new products coming out and a slew of new thinking about how to generate retirement income.

Among financial advisors and academics, the focus up to this point has been on generating a stream of income that rises along with inflation. But the problem is, if you own a portfolio that includes stocks, it's very difficult to generate that stream of income that rises with inflation, because short-term stock performance is all over the place. There's a mismatch there. I think what we're going to see in the years ahead is people are going to have to make a trade-off. You can go for something that is conservative that will give you that steady stream of income, but you'll give up return and you may have to give up principal. Alternatively, you can accept that your income will fluctuate much more from year to year, which will allow you to invest more in stocks, get higher returns and possibly leave more money to your kids.

IU: Do you think that lifestyle-type index funds are a safe route for the uneducated investor? Is that going to solve the problem?

Clements: I think target date retirement funds are a brilliant solution. We have a lot of investors out there who are very unsophisticated. These are people who don't have enough assets to attract the interest of a well-educated financial advisor, and they don't have the knowledge themselves to build a well-diversified portfolio, so it makes sense for them to go out and get one of these target date retirement funds where they have one-stop investment shopping. Sure, we can argue about whether these funds could be better diversified, whether they should have more in stocks, whether they're appropriate for everybody of a particular age group. But in the end, these funds are far better than what many folks will manage to build on their own.

IU: What was the market highlight of 2007?

Clements: As an investment junkie, what was great about 2007 was that we finally had change. The story of the decade up until that point was that foreign stocks beat U.S., value beat growth and REITs beat everything. In 2007, those trends finally started to break down. For market junkies, it made the world a little more interesting. And so far, things have remained interesting in 2008.

IU: Are you anticipating any particular trends in 2008?

Clements: Now you are asking me to look into my crystal ball, and I can tell you it's very, very foggy. The markets are a remarkably good antidote for overconfidence. Every time I think I know something, the market defies me. Maybe U.S. stocks will do a little bit better than foreign stocks. Maybe large-caps will beat small-caps. But am I going to bet good money on that? Not a chance.



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