The Man Your Fund Manager Hates Burton Malkiel has been saying since 1973 that professional money managers can't beat the market. Today his words are accepted wisdom. But a few questions remain. Like: how come international stock pickers are whipping their indexes?
(FORTUNE Magazine) – Few investment calls have been so right for so long as the one that Burton Malkiel made 26 years ago. In his book, A Random Walk Down Wall Street, Malkiel made the case, originally posited by the University of Chicago's Eugene Fama and other academics, that it is futile to try to pick winning stocks. The market, he wrote, is efficient: It so rapidly gathers information and incorporates it into stock prices that it's impossible for even the smartest investors to outguess the market consistently. The only strategy that makes sense is to invest in an index fund, one that blindly tries to reproduce--but not beat--the market's return.
Malkiel's thesis finally sank in with investors in the past decade--not least because in the 1990s all but a handful of active managers failed to keep pace with the market, as represented by Standard & Poor's 500 index. These days an average of $4.7 billion flows into index funds each month, and Random Walk (in its seventh edition) is back in bookstores.
Even so, the case for indexing is not quite closed. Fund managers say that the superiority of S&P 500 index funds in recent years says less about market efficiency than about investors' obsession with the narrow group of large-company growth stocks that dominate the S&P. FORTUNE writer-reporter Anna Bernasek caught up with Malkiel at Princeton University, where he teaches finance, and asked him to defend his arguments again.
FORTUNE: You've said a blindfolded chimpanzee throwing darts at the Wall Street Journal can do as well as the experts. Do you really believe that?
MALKIEL: Well, the analogy of the chimpanzee is a cute way of putting it, but what I really recommend is that you buy and hold the whole market. That's what you do when you buy an index fund. Today I feel more strongly than ever that for the average investor, an index fund will way outperform everything else.
MALKIEL: Because the evidence is stronger than ever. When I first wrote the book, it looked to me as if an index fund would beat maybe 60% or two-thirds of actively managed funds. The results have been even better than that. In the last three, five, and ten years, an S&P 500 index fund would have beaten 90% of them.
FORTUNE: Most fund investors have learned the hard way that the past tells you nothing about the future. Why are you so sure that index funds will continue to outperform?
MALKIEL: Here's why. All investors as a group have to own all the stocks in the market. As a group, they can't have a gross return different from the market's, because they have to own the market. Now, the average mutual fund charges expenses of 1.5% per year, while low-cost index funds charge 0.18%. If all investors are going to have the same gross rate of return as the index fund, no better and no worse, the expense ratio difference is going to give index funds an advantage year after year.
And let me give you a second reason: the tax advantages. The index fund just buys and holds, while a regular fund turns over its portfolio as much as once a year. As long as there is an upward trend in the market, you'll have to pay more tax with a regular fund. And that's why I'm convinced indexing is going to continue to be a winning strategy. It's logical.
FORTUNE: Any investing strategy that catches on tends to be taken to extremes until, inevitably, it doesn't work anymore. Won't that happen with S&P index funds?
MALKIEL: That's one of the things that concerns me. To the extent that people equate indexing with the S&P, and just buy the S&P, then that index could be overpriced relative to the market. But if you take my definition of indexing, you own the whole market--not just the S&P. You can do that now: Fidelity, Vanguard, and a lot of others have total stock market index funds, which are based on the Wilshire 5000 index. If you choose one of those funds, you won't have that problem.
FORTUNE: Can you ever really own the whole market?
MALKIEL: If you use a broad capitalization-weighted index, you'll reproduce the gross investment return of all investors. The Wilshire 5000 is the closest thing we've got. It represents almost the entire investable universe.
FORTUNE: International fund managers have trounced their indexes for most of this decade. If the market is efficient, how can that be?
MALKIEL: There are potentially some subtle problems with indexing because of how an index may be constructed. In the 1990s active international managers have been beating the index, the EAFE--Morgan Stanley's market-cap-weighted index of Europe, Australia, and the Far East. The reason is that in the late 1980s, at the top of the Japanese bubble, Japan was two-thirds of the EAFE. Once the bubble burst, anyone whose portfolio was less committed to Japan than that beat the index.
I would argue that it wasn't because active managers know how to pick stocks. It was because the weighting in the index is not necessarily the appropriate one. Japan has 30% of the GDP of EAFE; had you put Japan in the index at that weight rather than at its market-cap weight, the index would have outperformed everyone.
FORTUNE: Emerging-markets managers also beat the index.
MALKIEL: It's the same problem there. To the extent that people have beaten the emerging-markets index, I would say it's because we don't have the best index in place.
FORTUNE: Doesn't indexing fail in emerging markets because those markets are inefficient, and active managers, if they work hard enough, can find undervalued securities?
MALKIEL: I don't accept that argument. Precisely because those markets are inefficient, indexing should play an even greater role. The spread between Bid and Ask prices in emerging markets, for example, is so large, and liquidity is so poor, that the cost of getting in and out is great. A buy-and-hold strategy, which is what you get with indexing, is at least as important in these less efficient markets, because transaction costs will kill you. But you want to be careful about what's in the index, and I think you particularly have to be careful when using a cap-weighted index that the weightings are appropriate.
FORTUNE: If you can't trust international indexes, you can't very well index your international stocks.
MALKIEL: I would say that's less a concern, because today Morgan Stanley has put together an international index with a set of weights that makes a great deal of sense to me. It's called the All Country World Index Excluding the U.S. Have there been problems with indexing for international investors? Yes. Are we on the way to solutions? I think we are.
FORTUNE: Why do market-cap weightings work in the U.S. but not in international markets?
MALKIEL: It's not that they don't work but that they become a problem if there is a bubble in a country. The Japanese example was an extreme case. It could be the same in the U.S., say, if the Internet sector made up 50% of the S&P. Then we might see that a cap-weighted index gave you a quite skewed proxy for the U.S. market too.
FORTUNE: What if everyone owned index funds? What would happen to returns then?
MALKIEL: There's a paradox about this. It's actually the professionals' reacting immediately to news that makes the stock market efficient. So it's theoretically possible that if 99% of the market were indexed, indexing would stop working. There'd be no one left to make the market efficient. But only about 10% of money is indexed now. I'd say we could have half of the money in the market indexed, and there would still be plenty of people to make it efficient.
FORTUNE: Are the days of the star fund manager over?
MALKIEL: We're seeing it now. Magellan has had a good performance this year, but the Vanguard 500 index fund still attracted a lot more money. [Of course, Magellan is closed to most new investors.] In fact, the Vanguard fund is now almost the same size as Magellan. My guess is you'll see it overtake Magellan within a year.
FORTUNE: Still, there are some managers who have beaten the index. Why are you so sure that a smart manager can't spot market inefficiencies and take advantage?
MALKIEL: The trouble with that notion--that you can find an anomaly and exploit it before anyone else--is that you never know whether what you've found is a real inefficiency or a statistical illusion. Maybe you see that you get excess returns if you buy stocks that have a ticker symbol where the first letter is B and the last letter is C. You can find this kind of anomaly. The question is, though, Have you really found anything meaningful?
FORTUNE: But there are also well-documented, persistent exceptions to market efficiency, like the tendency of small stocks to go up in January.
MALKIEL: I'm a skeptic. Suppose we observe that the stock market goes up in the first five days of January. Then I buy the last day in December, and I sell the fifth day in January. If enough people do it, the market doesn't go up the fifth day; it goes down because everyone is selling. Moreover, the market goes up the last day in December, so now you have to beat the gun by buying on the second-to-last day of December. Sooner or later there won't be any January effect. I think any anomaly will eventually self-destruct. There are just too many smart people out there looking for them.
FORTUNE: What about the Internet? Huge returns are being made there.
MALKIEL: That's clearly a speculative bubble. My own view is that this is dangerously close to the boom in biotechnology stocks of a decade ago, the Nifty Fifty boom of the early 1970s, and the bubble in Japanese stocks that ended in 1990. I think it's going to come to a very bad end. It's not that the Internet isn't real. But if we look back ten, 20 years from now, we'll find a lot of these valuations are absurd. There will be some winners, but I think it's extremely dangerous and a lot of people are going to lose a lot of money.
FORTUNE: Have you bought Internet stocks yourself?
MALKIEL: Yes, absolutely! What would I say to someone who is able to get new issues and flip them out the same day after they go up? "God bless you. Do it." I've done it myself. But my view on how you play the Internet is to have a portfolio of the Intels, the Sun Microsystems, and the Ciscos of the world. That is a more sensible way of playing the Internet than buying the Priceline.coms of the world.
FORTUNE: We're so used to high double-digit returns from the stock market. Can it last?
MALKIEL: Going back to 1926 we've had returns of about 11%, and even further back we got returns like 9% or 10%. Recently we've been doing 16% or 17%. It's unrealistic to think we're going to keep doing that. It wouldn't surprise me to see single-digit returns in the future. And, in fact, one of the things I warn people about is having unreasonable expectations.
FORTUNE: What happens to index funds when the market falls?
MALKIEL: They won't look quite as good. Index funds don't hold any cash, because if you're going to track the index, you've got to be 100% invested. Actively managed funds hold about 5% cash. So, when the market goes down, index funds will lose a little of their advantage because they're 100% invested and the other people are 95% invested. In this case index funds will continue to outperform but not by as much.
FORTUNE: What should individual investors who share your worries about the market do right now?
MALKIEL: The only solution is to be diversified. If your entire portfolio is in Internet stocks, I would pull back. If your entire portfolio is in common stocks, look very carefully at the 8% returns of some of the corporate bonds or the 6% tax-free returns from triple-A municipals. I would make darn sure that some of my portfolio was in these safer types of things. There's no complete solution to eliminate all risk for everybody, but having diversified into stocks, some bonds, real estate, and cash will help. It may be a boring solution for people, but that would be my advice. It's tried and true, and, particularly now, it's very important.