The Long View

The influential author and researcher shares his views on retirement income, asset allocation, equity valuations, whether indexing has gotten too big, and more.

Episode Notes

Our guest this week is Dr. Burton Malkiel. Dr. Malkiel is the Chemical Bank chairman's professor of economics at Princeton University. And he's also author of the widely influential investment book, "A Random Walk Down Wall Street." He's also the Chief Investment Officer at Wealthfront. He's a longtime professor in economics at Princeton, where he was also chairman of the economics department. Before that, he was the dean of the Yale School of Management, and William S. Beinecke Professor of Management Studies there from 1981 through 1988. Dr. Malkiel has served on boards of directors of several firms, including the Vanguard Group and on the investment committees of Active Investment Advisors, and the American Philosophical Society. Dr. Malkiel began his career in the investment banking department of Smith Barney & Co. He holds a BA and MBA degrees from Harvard and a PhD from Princeton University.

Morningstar Active/Passive Barometer

Rekenthaler, J. 2018. "The Paradox of Skill.” Morningstar. Dec. 17, 2018.

Episode Transcription

Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance for Morningstar.

Jeff Ptak: And I'm Jeff Ptak, global director of manager research for Morningstar Research Services.

Benz: Before we get into the conversation, we wanted to share some exciting news. The Morningstar Investment Conference for investment professionals will be held virtually this year on Sept. 16 and 17. We're offering the same research, analysis, and insight you'd get at the live event for a reduced price of $149. And the best part is you can join us from wherever you are. For more information or to register, visit go.morningstar.com/mic. Again, that website is go.morningstar.com/mic. I'll be speaking at the virtual MIC. I'd love to have some of our Long View listeners join us there.

Now, let's get into the episode. Our guest today is Dr. Burton Malkiel. Dr. Malkiel is the Chemical Bank chairman's professor of economics at Princeton University. And he's also author of the widely influential investment book, A Random Walk Down Wall Street. He's also the chief investment officer at Wealthfront. He's a longtime professor in economics at Princeton, where he was also chairman of the economics department. Before that, he was the dean of the Yale School of Management, and William S. Beinecke Professor of Management Studies there from 1981 through 1988. Dr. Malkiel has served on the boards of directors of several firms, including The Vanguard Group and on the investment committees of Active Investment Advisors and the American Philosophical Society. Dr. Malkiel began his career in the investment banking department of Smith Barney & Co. He holds B.A. and MBA degrees from Harvard and a Ph.D. from Princeton University.

Benz: Let's start with the big picture. Bond yields are really very low today, so low that for retirees they may not support the 4% spending guideline that a lot of retirees look to. That presents a quandary for people who are entering retirement or already in retirement. Can you talk about how you would recommend that they approach this really difficult environment where income production really isn't the force that it once was in retirement?

Malkiel: Sure. Well, we are definitely in a low-return environment and with the case of the bond market, more than half of the sovereign bonds in the world are actually selling at negative interest rates. There's no question that that presents a major challenge for retirees. And I don't think there's a very easy answer except that I think it means that people will need to save more, and maybe even retire later. There isn't an easy answer. The 4% rule, which had been time honored, is I think no longer valid. I recommended in the last edition of my Random Walk book that maybe one ought to think of 3%, and it's quite possible that a 3% takeout rate is too high.

Now, I think it also presents a major issue for those who want a diversified portfolio, and I think everybody should have a diversified portfolio. What does one do for the so-called fixed-income part of the portfolio when bonds basically give you what's essentially a zero rate of return? The 10-year Treasury last time I looked was yielding 0.6 of 1%.

My answer is that I think one probably needs to take a bit more risk on that stable part of the portfolio. And one asset class that I have recommended is preferred stocks. There are good-quality preferred stocks, which are basically fixed-income investments. They're not as safe as bonds. Bonds have a prior claim on corporate earnings. But I think when you look at a preferred stock of something like JPMorgan Chase, I don't think you're taking an enormous amount of risk. The banks now have much more capital. They are constrained by the Federal Reserve in terms of what they can do and buying back stock and increasing their dividends. And with a portfolio of diversified, high-quality preferred stocks, one can earn a 5% yield.

What I have suggested is that I think one needs to think for the bond part of the portfolio--and I do think we need some part of the portfolio to be in safe assets--that one ought to think about preferred stocks, or what I call bond substitutes, for at least some part of that portfolio. And if one wants to take on even a bit more risk, there are high-quality common stocks that also yield 5% or more: a stock like IBM, which has a very well-covered dividend, yields over 5%; AT&T-- you can think of basically blue chips and they might play a role. I think we do need diversification. We do need some income-producing assets in the portfolio. But my recommendation is that you think in the diversification of not simply bonds, but maybe some bond substitutes along the lines I've just mentioned.

Ptak: Do you worry that this might change the form of the problem from outspending one's savings and income to pushing too far out on the risk spectrum for comfort? After all, some retirees are perched on the razor's edge and can’t afford to experience a big drawdown. You've described, to your great credit, some of the risks that one could court even preferred stocks and diversified dividend-paying, high-quality equities. But how should a retiree think through that trade-off that they might be making if they are to swap out some of their bonds for some of these other alternatives that you mentioned?

Malkiel: Well, there's no question that there is a trade-off; there is going to be a little more risk in the portfolio. And one needs to recognize that. Unfortunately, I don't believe in alchemy. I just don't know that there is a perfect solution. But as part of the solution, we go back to the spending rule. I think that one has to think if one is worried about outliving one's money that the spending rate has to be less. In part, it means maybe a bit more belt-tightening. There's no easy answer to this. I wish there were an easy answer that there's a riskless way to solve the problem. But there isn't. And I think in terms of wanting more safety, one ought to be saving more before retirement, and maybe the answer is to be spending less in retirement. As I say, no easy answers. There are trade-offs. But I do think that at least for some part of the less-risky portfolio, that on a relative-value basis, things like preferred stocks, and some of the blue chips that have good dividends, and dividends that have been rising over time, ought to play at least some role in the portfolio.

Benz: Do you think nonportfolio assets should be a bigger part of the discussion around asset allocation in retirement--like simple immediate annuities, reverse mortgages, and so on? And will those need to be a bigger part of the calculus for many retirees?

Malkiel: The problem with something like annuities, it certainly has the advantage of if you buy a fixed annuity that is going to pay you $500 a month for life, you've certainly reduced the risk of running out of those $500 a month. The problem that I have with them is that many annuities are sold by insurance salesmen and the commissions are very high and the expense ratios are very high. Now, again, when you are in a low-return environment, and somebody charges you 100 basis points of expense--never mind the commission at the beginning, which is also hefty--that 100 basis points, you might say, “Oh, it's nothing, it's only 1%.” But if the diversified portfolio yields 4%--for the sake of argument, that's a quarter of the income of the portfolio. And the problem that I have with annuities is, in theory, they ought to have a role in the portfolio, but very few of them are really good values in that they have very high expense ratios and also very high sales charges. If one is thinking of an annuity--and I'm not objecting to somebody very risk-averse thinking that that ought to be part of the picture--that one ought to go to a place like Vanguard where you know that there won't be a sales charge, you know that they will do something for you with the minimal expense ratios; or maybe you go online, and there are apps now that will price annuities everywhere. Be a smart shopper, and make sure you get one with no sales charge and with expense ratios as low as possible.

Benz: Potentially there are conflicts all around this topic though, right? There are advisors who are compensated based on assets under management who might have seen all of the academic research about the benefits of annuities, but still might be disinclined to recommend them given that the amount that goes into the annuity comes out of their book of business. It seems like it's just a conflict-ridden area.

Malkiel: It is potentially an issue, but it may cut the other way that the advisor who puts an annuity in your portfolio may earn a very high sales commission for doing it. And while it's not a long-run maximizing strategy for the manager, it may very well be a short-run maximizing strategy. It depends upon how your advisor is paid. And many advisors, as you know, get paid for selling particular products. And that may be a short-run income-maximizing technique that the investment advisor will use, and the investment advisor could very well be conflicted.

Ptak: I wanted to shift to asset allocation. The U.S. 60-40 allocation has served investors exceptionally well. But with equity valuations this high and bond yields this low as we covered earlier, it sounds like based on some comments I've read of yours, you'd advocated different approaches. What does the new 60-40 look like?

Malkiel: Well, both in my book and in my work as chief investment officer of Wealthfront, we have strayed from the 60-40 allocation. And I think in this age of what I've called financial repression, where safe bonds yield next to nothing, that I think the 40% is too high. Now, of course, there's not just one figure that fits all. For some people it might be 60-40 would be OK. But I think, in general, the asset allocations that I have recommended have a much larger equity allocation and a much smaller bond allocation. And if you look at the 12th edition of my Random Walk book, you'll find that I have generally reduced the fixed-income allocation and increased the equity allocation--different amounts for different age groups, but generally, far fewer bonds. Now, what we do at Wealthfront, for example, particularly in the more aggressive portfolios for those people who can stand the risk, we have very little, certainly nothing like 40, not even anything as high as 20. As I say, I don't think you can make a specific number because people are different, and people need different allocations. But as a general rule, I would say the 40% fixed income should be lower, and I think at least some part of that ought to be in bond substitutes rather than in either government or even high-quality corporate bonds and stuff.

Benz: I wanted to follow up on Wealthfront's allocations. Speaking of young clients who might have those heavy overall allocations to equity, what percentage of that would typically be allocated to non-U.S. assets?

Malkiel: Well, in general, I have been a supporter of a larger international allocation than I think most people would recommend. And I do so for the following reasons. There is a secular problem that we have in the United States, and that is that we are aging rapidly and that our population is growing far slower than it did in the past. And even if productivity stayed constant--which it hasn't, it's actually been falling--what that means is that growth in the United States is likely to be lower than it has been in the past, and particularly lower than it's been in the years from the end of World War II into the new millennium.

I think this is also true of Europe. And it's particularly true of Japan. Very soon Japan is going to have more nonworkers, that is people who are retired or children, than they have actual workers. Japan is losing population. Japan will lose a third of its population or more by the year 2050. You're just not going to get the growth in the West and in the United States that we've had before. At the same time, where you find populations growing and where they're younger, is in the emerging markets. In a place like Vietnam, there's an enormous difference in terms of the average age, in terms of the growth of the population. And I think what you're going to see there is that the emerging markets are going to grow very much faster than the developed markets. And therefore, one of the differences that you will see in the Wealthfront portfolios that I advise, and that I advise in the Random Walk book, is a much greater international allocation, and specifically within that international allocation, more for emerging markets. Growth is the first argument.

The second is valuation. What we have seen in the United States is we know our stock market is quite richly valued. The metric that I use is the CAPE Ratio or the Cyclically Adjusted P/E ratio. Sometimes it's called the Shiller P/E ratio. And the reason that's the metric that I favor is, it's pretty hard – you can't predict the short-run movements in the market. It's very hard to predict long-run movements. But to the extent that long-run returns can be forecast, the CAPE is the best forecaster of long-run rates of return. There is an R-squared of 40%, i.e., you can predict about 40% of the long-run rates of return of the stock market from the CAPE ratios. When CAPE ratios are very high, as they are now, long run--and by long run I mean 10-year rates of return--tend to be low. When CAPEs are very low, long run 10-year rates of return tend to be high. CAPEs are quite high now, suggesting that long-run rates of return are going to be low. I'm not saying you sell all your stocks because the stock market is high. Everything is high. But it does suggest that if the safe bond market yields zero, over time since 1926--where we have very good data--the stock market has given a rate of return of 10% per year, dividends and capital gains, i.e., bonds have given 5% over that period. There's been a 5% risk premium. Suppose the risk premium is the same, the suggestion would be that stocks are only going to give you 5% or 5% to 6%. The CAPE Ratio says the same thing. CAPE ratios, I think, are the best predictors that we have.

Following on that, our CAPE ratios have been rising and rising rapidly. They're not as high as they were during the dot-com bubble, but they are pretty darn high, and they are somewhere around where they were in the late 1920s. On the other hand, people have detested emerging markets. Emerging markets haven't done very well recently, and they haven't done well not because earnings haven't been rising. They haven't done well because CAPE ratios have been falling. And in emerging markets, CAPE ratios are well below average at the same time that they are well above average in the United States. That suggests to me a somewhat higher allocation to foreign and particularly a somewhat higher allocation to emerging markets than we have generally done and what generally investment advisors will recommend. And my feeling about this is reflected in the 12th edition of Random Walk. The paper book has just been published earlier this year, and in the Wealthfront portfolios.

Ptak: I wanted to talk about the S&P 500 index, the flagship U.S. index, in many investors' opinions. It's gotten pretty bunched up in its top holdings. I think as of a few days ago when we looked, the top 10 names soaked up not quite 30%--around 27.5% of the index's weight--which is about as high as it's been at any point over the past three decades. I'm curious to get your perspective. Is that a worrisome development? I don't know that we could argue that it's a defect of the index, because the index is reflecting what's happening in the market in aggregate. But by the same token, that is a pretty large concentration--the top 10 names in absolute and relative terms. What do you make of that?

Malkiel: Well, let me repeat what the general argument of the active managers would be. And that is exactly what you said. The top holdings--the Apples, the Amazons--are too big a weight. And look back to the dot-com bubble, you had the same sort of thing. And boy, this is the time for a stock-picker. This is the time to be an active manager. This is exactly the time that you don't want to be an indexer. Well, when you look at what active managers hold, they're also holding an outsize proportion of the Apples, the Amazons, the Googles, or Alphabets, the Microsofts, and so forth. And they had an even bigger holding of the dot-com stocks at the end of the 1900s.

It's an argument that I hear all the time. And it's often used as an argument that you don't want to index; you want to be in an active fund. And I don't think it holds water because I don't think there's any evidence that there are particular times where active managers outperform. If you look at the SPIVA data from Standard & Poor's, you find year after year active managers are outperformed by the S&P. And, in fact, if you look at a time series of this, it looks like it's getting harder and harder over time to beat the market. It's now been about 70% of active managers each year are beaten by the S&P 500. Those that win in one year aren't the same as those who win in the next year. And when you compound it over 15 years, you find that 90% are outperformed. I'm not saying that you can't find an outperformer. But it's like looking for a needle in the haystack. And when you go active, you're much more likely to be below average than above average.

Now, having said all of that, I just want to add one footnote. And that is that my own view is that while the S&P is fine, I prefer to be indexed to a total stock market index. I want to earn the whole economy. I want to be invested in every stock, not simply the S&P. And what that would do is it slightly reduces the weight of the big favorites now of the Amazons and Microsofts and Facebooks and so forth.

Ptak: That makes sense. I do want to ask a follow-up. As we know large and growth in the U.S. has really trounced small and value going on well over a decade now, which kind of upends what had been the conventional wisdom, at least amongst those that are adherents to factor investing and the idea that there are risk premium--you get a payoff for investing in small and for investing in value and that hasn't really played out over the past decade plus. The S&P does tilt increasingly toward large and some of these growth names. Do you think an argument can be made that one should be looking even more intently at small caps and value given the fact that they have underperformed to the extent that they have?

Malkiel: Well, let me tell you, actually one of the biggest mistakes that I have made in my investing career because I thought exactly the way that you just suggested that you could, in fact, look at periods where value had underperformed over some period of time, and then think that you could then shift from growth to value, and do well. So, I played with this. I actually did a fair amount of empirical work as an economics professor at my university, and had some wonderful back-tests, where in fact, if you bought value, particularly when it was cheap relative to growth, you did very well. And I did some of this work in the 1980s and 1990s. And it worked wonderfully in the back-tests. But then when you looked at trying to do this in actually making excess returns in the future, it seemed to all fall apart.

One of the things that sort of changed my thinking, and it's the kind of general idea of why I called my book A Random Walk. These things are just so difficult to predict. I know value is cheap. I know small cap is cheap. But if you think of just factor investing as a way to get excess returns, I think it's totally undependable. I understand the argument. It seems to make sense. It seems to be quite plausible. But I've fooled myself in the past thinking that you could do it. And I'm now far more skeptical. I just don't think anyone can do it with any accuracy. Value looked extraordinarily cheap relative to growth last year and two years ago. And look what's happened. You have absolutely gotten killed with holding a value portfolio. I do not recommend that anybody try to do it. I tried it myself. I think it was a mistake. I'm not sure anyone can do it. And I think the record of these factor funds that concentrate on one factor only have not been good investment outlets for people.

Benz: You've indicated that a multifactor approach to investing is a viable alternative to traditional cap-weighted indexing, as some might derive diversification benefits from the lower correlations among the factors. Practically speaking, that might mean ramping up exposure to small value and momentum and so on. But how should an investor know whether they've correctly calibrated their exposure among those different factors?

Malkiel: No, you're quite right. But to the extent that you want to do factor investing, I think you've got to do it with a multifactor approach because it's not simply low correlations among the factors. It's that you get some negative correlations. For example, value and momentum are negatively correlated. And the empirical work that I have done suggests not that you're going to get a higher rate of return. It's not that this is an easy way to outperform. What a multifactor approach does, because of the low and sometimes negative correlations among the factors that you get a somewhat higher Sharpe ratio--the Sharpe ratio being basically return or excess return divided by volatility. You can get the volatility down a bit. And for those who get extraordinarily worried when the value of their portfolio fluctuates wildly--as it does, and as it did earlier this year--with a very volatile stock market, this does tend to tamp down the volatility somewhat. And now the question is: If you're going to do it, how do you do it? Most multifactor funds are very, very high cost. And that would take away any advantage that the funds might have. And I think you want to look for a multifactor fund that has low costs. Again, I'm not trying to sell any particular investment product. But two of them that I think fit the bill--there's a Goldman Sachs Multi-Factor ETF with an expense ratio of less than 10 basis points. There's a Vanguard one with a very low expense ratio. If you do it, don't think this is the answer to investing and you're going to outperform the market, you won't. But you might have a bit less volatility and a low expense when that has an expense ratio, not very different from a total stock market fund, is an investment product that I think is a reasonable holding for people.

Ptak: We're going to talk about indexing in a moment. But before we do that, Wealthfront had launched a Risk Parity Fund I think a couple of years ago, if I'm not mistaken. My question for you, I think I've heard you explain the underlying investment rationale for it, and it goes something like: markets and investors, they tend to underrate the utility of stable, consistent, but boring assets. Those are the sorts of assets that you can lever up as part of a risk strategy, a risk parity strategy in achieving parity risk-wise between the different types of assets. My question for you is, why this market inefficiency exists in the first place, and why you would feel confident it would persist into the future?

Malkiel: Well, I do think--again, in the past, this has been an empirical regularity. I've done a lot of empirical work in the stock market, and I've even done some in the horse racing markets. And what I found very interesting, and this seems to be quite consistent, and it's one of the reasons why I have a chapter in my book about behavioral economics because I think there is something to it. There is something to regular behaviors of people. In the racetrack if you bet on every horse in the race, you will have a winning ticket because some horse will win. But if you keep doing that you will lose 20% of your money. Why do you lose 20% of your money? Well, because when the odds are figured, they're figured after the track takes out 20% of the betting pool for their profits, for taxes, for operating costs, and so forth. Racetrack betting may be a lot of fun. I enjoy going to the track from time to time, but it's not a profitable enterprise.

Suppose instead of betting on every horse in the race, you bet on every favorite in the race. You'll have a winning ticket about a third of the time, which is good, but you'll lose about 4% or 5% of your money. Now, let's say, instead you like the thrill of buying a ticket on a long shot, you'll win very infrequently. And if you bet on every long shot, you'll lose 40% to 50% of your money. In other words, favorites do not go off at as high odds as they should. And long shots tend to be over bet. How do you explain it? It's, I think, a behavioral aspect of markets. And I do think that behavioral economics has some wisdom about how markets behave. It does suggest that safer horses--there's nothing that's really safe--go off at higher odds than they should, and long shots go off at lower odds than they should. People over bet long shots, under bet favorites. And they appear to do this in the stock market as well.

Let's say that you are a person who will accept the volatility and risk that comes with the stock market. Assume then that you buy the safest stocks, which have a little less volatility than the stock market as a whole. And we leverage them up by buying a little bit on margin to bring the volatility up to the volatility of the stock market, then presumably, you will have a higher rate of return. And it turns out that bonds have had lower volatility than stocks. Let's say that instead of buying a stock portfolio, maybe what we ought to do is buy a portfolio of safe bonds, leverage them up, which will, as long as the borrowing rate is less than the bond rate, as long as the yield curve has a positive slope, that will increase your rate of return and increase your volatility. And this can possibly give you a higher rate of return for a given risk than simply buying the higher yield, higher-volatility assets. That's the general idea of risk parity. It's, in fact, worked in the past.

And now, let me get to your question of will it work in the future? I have a discussion in the 12th edition of my book that suggests that you might not want to count on it. And the reason you might want not to count on it is the factors that we have just talked about--about financial repression and keeping bond yields very low. If you worry that at some point with all of the fiscal stimulus, with all of the monetary stimulus, with the Federal Reserve having pushed up their balance sheet by $3 trillion, with $3 trillion of fiscal stimulus in the United States, and probably another $1 trillion or $2 trillion to come, if you worry that at some point after COVID-19 that some kind of normal fee will continue, and we've seen that it's very hard to then retract-- the Federal Reserve had a lot of trouble trying to reduce its balance sheets in the past. Its balance sheet is now way over-inflated. Europe has done the same thing. I think that we've got to worry that inflation that everybody now thinks is dead is not necessarily going to be dead forever. And if, God forbid, we have another inflationary episode, which I think is absolutely a possibility--I'm not predicting it, but it's absolutely a possibility--then risk parity will be a very dangerous strategy, because the safe bonds will go down in price as yields rise with inflation.

Benz: We want to go back to indexing to talk about the growth of indexing. Do you think it's potentially contributing to making the market more inefficient than it was before?

Malkiel: Well, I don't think it's contributing to market inefficiency. If you think that inefficiency means that stocks are not priced appropriately, and one is able to outperform the market, the evidence again from the SPIVA data suggests that along with indexing growing from 20% of mutual funds to 30% to 40%, to now over 50% of mutual fund assets. In fact, the ability of active portfolios to beat the market has decreased. Fewer people are beating the market. There's no evidence, as indexing has increased, that it's been easier to beat the market. And presumably, if the market was getting more and more irrational, then rational investors ought to be able to do better. I see no evidence that as indexing has grown, that markets are becoming less efficient. I think if anything, the evidence is they’re becoming more efficient.

Ptak: I have a question about an area where I think you've said indexing does need to do better--principally Vanguard, BlackRock, and State Street, the three big players. But before we get to that, to what would you attribute the fact that pricing has gotten more efficient in markets? Is it something like the paradox of skill--the fact that you have marginally skilled players who are dropping out and opting for indexing, and that leaves a collectively more skilled pool of players to trade with one another, and the opportunities are simply less?

Malkiel: Sure. No, I think that is definitely a part of it. Fifty, 60 years ago, the market was much more influenced by individual traders. Now, the market is basically influenced 90% or more by professional traders. Maybe 100 years ago, the market was much more like the people who trade on Robinhood, the individual traders who basically push bankrupt Hertz from $1 to $5 and then back to $1. Maybe the market was very much more like that. But the market now is so professional that it's really harder and harder to outperform. That would be my explanation as to why it's harder and harder to outperform, and why, in my view, the market is getting more efficient, not less.

Benz: Speaking of Robinhood investors, I wanted to ask about the best way for young people to get started in investing. It seems like maybe one legitimate argument for someone starting with individual stocks is that you make mistakes, and you maybe get that casino mentality out of your system. What do you think is the best way for new investors to get started in investing? Say, they've got a graduation fund that they'd like to invest in; they'd like to take advantage of their nice long time horizon.

Malkiel: I think that probably the best thing to do would be to take on a mixed strategy. I mean, I think Robinhood is a great fintech company that's been very successful. I would say to people--and obviously I have an ax to grind since I'm the chief investment officer--I would say open up an account with Wealthfront, a fintech firm, you'll get diversification, you'll get tax management, you'll get automatic rebalancing, and you will pay a minimal 25 basis-point fee. And that's what you ought to do for your investing. If you have a little extra money, and you want to gamble--and I've got nothing against gambling--I think then you buy a few individual stocks, you try it out, that's just fine. I've been known to set up the blackjack tables in Atlantic City and in Las Vegas. Over time I lose money, and I just chalk it up to the fun of doing it. And investing in individual stocks is fun. I see no problem with doing it. But don't think that that's the way you ought to save for retirement. You ought to save for retirement by putting your money into some balanced portfolio with very low expenses.

And let me give you what is sort of my mantra, which is the following: any of us who work in markets, who have studied markets all their lives, you have to be very modest about what you know and what you don't know. But the one thing I am absolutely sure of--and there's not a lot about markets that I'm absolutely sure of--but what I am absolutely sure of is that the lower the expense that I pay to the purveyor of the investment product, the more there will be for me.

Ptak: I think that we can certainly say, with respect to the biggest index fund and ETF providers, that they've played a role in driving down expenses, and you would applaud that. But one of the things that you've noted is that those big three--Vanguard, BlackRock, and State Street, respectively--need to do a better job of engaging with firms and throwing their weight around during the proxy process. Can you give an example of how you think that might express itself? For instance, is it taking a harder line on executive comp? Is it taking a stand on things like workplace equity? After all, an index fund probably shouldn't be telling a firm how to allocate capital. I'm just curious how you think that they should be striking an appropriate balance between respective…

Malkiel: Let me give you one example of what I do applaud and let me take the compensation question that you raised. One of the things that BlackRock does, which I think is very good, is when they are looking at a firm's compensation, very often the firm executives would say: “Well, the stock has gone up, this shows you that we've done a great job.” What BlackRock looks at is: “Did you go up more or less than people in your industry?” In other words, if you're going to have performance compensation, what they have insisted on and have made their votes dependent on is relative performance, not absolute performance. I think there are a lot of things like that, that the State Streets and Vanguards and BlackRocks can do. I am not sure that they spend enough time doing this. But now that they are such major holders, I would advise them to spend a lot more time on this and make sure that they are protecting the individual shareholders because it is now more and more on their backs to do it. Because I'm like an active manager who, if I don't like the way a management is proceeding, you can just sell the stock; the indexers can't. And I think they've got to put a lot more effort into it and do much more of the things that BlackRock is doing than maybe they've done in the past.

Benz: We wanted to get your take on ESG investing. Do you view it as another form of active investing? And what kind of risk/reward trade-off should ESG investors expect to receive if they tilt their portfolios toward firms that they view as having greater ESG merit?

Malkiel: I'm frankly a skeptic about ESG investing. Because when I look at what is considered bad and look at what is considered good, I kind of scratch my head and say, is that really what I want? Let me give you an example. Let's take a company Kinder Morgan, which is a gas pipeline company mainly, that delivers natural gas. According to ESG investors, that's bad because it's carbon. And we don't want anything that has anything to do with carbon. On the other hand, we're not going to get rid of carbon right away and the cleanest-burning carbon is natural gas. And to the extent that Kinder Morgan can deliver natural gas to utilities and they can then replace their coal with natural gas, then it's a good thing. To the extent that the natural gas is delivered by pipeline rather than truck and rail where there can be accidents and which themselves create pollution, maybe they deliver it in a particularly good way. Am I going to be really happy with not having Kinder Morgan in the portfolio? If I don't have a utility in my portfolio because they burn a lot of oil but that they have been investing in wind and making sure that they are moving to a less-carbon-intensive production of power in the future. Do I not like them because their emissions are high right now? Or do I look at their plans for the future and applaud them? I think when you look at some of these companies, I don't find it as easy as some of the ESG people do to say: “We just don't want to invest in this, it's no good.”

Now, then on the other side, when I look at what ESG portfolios hold, I say to myself, “Am I really happy with those holdings?” One of the holdings that appears usually as a top-10 holding in ESG portfolios is Facebook. Now, am I really happy with holding Facebook? Is this what is a really good company? I find what passes for a good and moral portfolio, I have a little more trouble with. Now, in terms of returns, the empirical work--although returns, frankly, of ESG portfolios in the first half of 2020 have been very good, largely because oil companies have been a disaster in the first half of 2020. But over the longer pole, there is no evidence that ESG portfolios either outperform or underperform. On the other hand, if ESG investing continues to grow as it has, suppose then it means that all oil and natural gas companies have lower prices than they otherwise would because of the growth of ESG investing, then they're going to have higher future returns. And, if in fact, ESG investing continues to grow, it may be that you'll have lower returns from ESG investing.

When I look at the ESG portfolios, number one, I don't really feel I'm morally superior owning them when I look at what's in them. And, secondly, it is possible in the future--they certainly are going to be less diversified--and it's possible in the future that they could even have lower returns. As you can see, I'm not a big fan of ESG investing.

Ptak: Yeah, we can tell. For our final question, you were ahead of your time in recognizing indexing's utility and for seeing its eventual popularity. You advocated for it at a time trading was popular and active was thought to succeed on the whole. It was contrary. Do you see other innovations or ideas floating around right now that go against the grain and haven't caught on similar to indexing in the 70s and 80s, but which are convinced are the future? What's an example?

Malkiel: I definitely do. And I think the new revolution will be the revolution in advice, because investment managers who manage portfolios for people, if you have a wrap account with a broker, you may pay 2 or 3 percentage points. If you have an independent advisor, even a good one, it will be 1%. We're in a low-return environment. That's going to take up a massive proportion of your return from investing. And I think that the next revolution is going to be the revolution in advice. This is the reason that I joined Wealthfront. This is the reason that I wanted to be a part of that revolution, where we could do some of the tax management and automatic rebalancing, any of the things the good diversification that people need and can do it with software and can do it for far less than the face-to-face manager can do. I think there's going to be a lot more of that. I think that's the next revolution, and I'm very proud to be a part of it.

Benz: Well, Dr. Malkiel, this has been such a great conversation. It has really been a treat to get your insights. Thank you so much for taking the time to be with us today.

Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.

Benz: Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)

The Long View

Burton Malkiel: 'I Am Not a Big Fan of ESG Investing'

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