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Malkiel Encouraged by Indexed Products

Christine Benz

Christine Benz: You're a big proponent of efficient-markets hypothesis. Are you encouraged by the strong uptake we have seen of index-based products? Even though we have not seen great flows into equity funds, we have seen a lot of uptake of exchange-traded funds in particular over the past several years.

Burton Malkiel: I am. I think, in general, the more plain-vanilla of these have been absolutely wonderful for investors, and I am extremely encouraged. You know, a number of people will say to me, "Burt, aren't you discouraged that maybe for individuals, maybe 25% to 30% of their money is in indexed-type products, and you've been on this indexing bandwagon for 40 years. Are you discouraged?"

I'm not a bit discouraged. I mean, I'm a glass-half-full guy rather than a glass-half-empty. I think that ideas that really started in the academy have had a lot of uptake in the real world. I think, it's been good, I think it's going to continue, and I think we're going to see more and more of it. I am very encouraged about the growth of what I would call the more plain-vanilla, very broad-based, very low-cost indexed products.

Benz: How do you feel about the different higher-cost products that we have seen launch over the past several years. We have certainly seen a lot of very specialized ETFs which seem like maybe not the types of products that people will use well?

Malkiel: I think that is very bad. Unfortunately, a lot of people when they think of ETFs, they think of some of these products, and it gives the whole ETF world a bad name. I think that it's crazy to buy something that will give you 3 times the S&P 500 on the upside or the downside. These products really have nothing to do with investing, and in fact, they don't even do what they purport to do. They will do it for one day. You can't be a long-term holder of these and get what they tell you they are going to give you. Those more specialized ones and more speculative ones are, in my view, very, very troubling. As far as I'm concerned, they are very gimmickry, and they are typically, as your question suggested, high-cost.

But does this undermine the case for indexing? No. It says, these aren't really true indexed products. What I am talking about when I talk about an indexed product is a very broad-based product that if it's for the United States, it would be a total stock market indexed fund and would include all the stocks in the U.S. And if it were a European product, it would include all the ones for Europe and would be low-turnover and low-cost. And that's what I mean by indexing and good ETFs. I certainly wouldn't include some of the products that are high-cost and gimmickry.

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Benz: One related question is that we have seen in general equity market correlations rising certainly here in the U.S. when we look at stock types. We have seen a lot of convergence in terms of performance. Do you think that that's a result of increasing uptake of indexed products where you have seen stock types of varying sizes and styles moving in the same direction?

Malkiel: Well, let me make a couple of points on this. It is possible that indexing would help drive some of these correlations together because after all if people are going into a market, they are going to be buying all of the stocks. And if they are selling indexed products, they are going to be selling all the stocks. So, there might well be some tendency for that to happen.

Now, what's interesting is, let's assume that that's correct. I'm not going to tell you that it's necessarily correct, but let's say that that's correct. Two things seem to follow as arguments that are, in my view, not correct.

The one view that people seem to argue is, well, that means that active management will beat indexing. It will be much easier. After all, if everything moves up and down together and they shouldn't then active managers ought to be able to outperform an index because all the drug stocks are going up together, even the lousy ones, so what we know is that as an active manager if we're in the better ones, we will do even better. And that doesn't seem to follow because I don't see in my own work that active management is getting better and better over time. Quite the contrary. I think as I look year by year, I don't see any tendency for active management to be doing better even if correlations between stocks have risen.

The other point is, you hear sometimes, "Correlations are all so high now that diversification doesn't help you because when equity markets go down, all the equity markets go down." And that's true that there has been, certainly globally, the kind of argument that people used to use for international diversification is that markets wouldn't move together.

Well, the ups and downs are more highly correlated, but that doesn't mean diversification doesn't help you. If you take, let's say, a decade like the lost decade--and I'm using the term lost decade as the first decade of the 2000s; it's often called the lost decade because the S&P ended up about the same place where it began. You really didn't make any money holding an S&P 500 fund. So, let's just take that loss decade. The correlation between emerging markets and the S&P 500 was very, very high in that decade, but that didn't mean you didn't want to be in emerging markets, because emerging markets gave you returns of about 10% a year and the S&P gave you returns of 0% a year. Remember that with a correlation, all you are seeing is the ups and downs tend to be correlated. When one is up, the other is up; when one is down, the other is down. But that doesn't mean that the performance is going to be the same.

The emerging markets ups and downs were highly correlated with the S&P, but the performance was quite different. I think even if that's right, don't take away from that, that therefore you don't want to be diversified. I think you still want to be highly diversified. Not all asset classes are more highly correlated. Certainly stocks and bonds have been much less correlated over the last decade than they have in the past.