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  • Bogleheads on Investing with Dr. Burton Malkiel – Episode 23

Bogleheads on Investing with Dr. Burton Malkiel – Episode 23

Post on: June 10, 2020 by Rick Ferri

Our July 2020 guest is Dr. Burton Gordon Malkiel, an American economist and writer, most famous for his classic finance book A Random Walk Down Wall Street (now in its 12th edition).  He is the Chemical Bank chairman’s professor of economics at Princeton University and is a two-time chairman of the economics department there. Dr. Malkiel is a leading proponent of the efficient-market hypothesis, which contends that prices of publicly traded assets reflect all publicly available information, and one of the original thought leaders of that lead to the creation of index funds. 

Dr. Malkiel served as a member of the Council of Economic Advisers (1975-1977), president of the American Finance Association (1978), and dean of the Yale School of Management (1981-1988). He also spent 28 years as a director of the Vanguard Group. He currently serves as Chief Investment Officer for Wealthfront Inc. a software-based financial advisor, and as a member of the Investment Committee Member for IRA Rebalance, an investment advisory firm. 

You can discuss this podcast in the Bogleheads forum here.

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Rick Ferri: Welcome to Bogleheads on Investing episode number 23. Today our guest is Dr. Burton Malkiel, a Princeton economist and the author of A Random Walk Down Wall Street, first published in 1973. This book was an inspiration for Jack Bogle to start the first index mutual fund.

Welcome everyone my name is Rick Ferri and I’m the host of Bogleheads on Investing. This podcast, as with all podcasts, is brought to you by the John C. Bogle Center for Financial Literacy, a 501c3 non-profit organization that can be found at boglecenter.net. Today our special guest is Dr. Burton Malkiel. He needs no introduction to many of the Bogleheads. Dr. Malkiel received his undergraduate and master’s degree from Harvard University and then went on to Princeton University to receive his PhD., where he started a long and illustrious career. Back in 1973, he wrote a book called A Random Walk Down Wall Street where he called for the first index mutual fund to be created, which led to the index fund revolution. With no further ado, Dr. Burton Malkiel. Welcome Doctor.

Burton Malkiel: Thank you very much.

Rick Ferri:  Before we get into the nuts and bolts of investing, because we have a lot of topics to talk about, a lot of them come from your latest edition of A Random Walk Down Wall Street, and then there’s other things that we’ll be talking about, but this will be an investing show. But before we get into that if you could tell us some of your early background, like where you grew up, where you went to school and how you got involved in the investment industry.

Burton Malkiel: Well I grew up in the city of Boston, in a part of Boston, Roxbury, Massachusetts. I grew up in a tenement house. For some reason I was always interested in numbers and even though I had no money and my family had no money to invest in the stock market, I knew the price of General Motors stock just about as well as I knew Ted Williams batting average. So this is something for some reason that interested me, followed me through my youth.

I went to college and majored in economics and then went to business school, much to the regret of some of my economics tutors, who said, “You’re really a very good economics student, you ought to go into the academy.” And since I had grown up poor I decided that the academy wasn’t for me. I didn’t want to continue to be poor. I wanted to go to Wall Street, which had interested me since I was a little kid. And so I got a jump with Smith Barney, the investment bank that’s now part of Morgan Stanley.

Rick Ferri: But Dr Malkiel, this wasn’t just any business school, you received your bachelor’s degree and MBA from Harvard University.

Burton Malkiel: Well that is true, that is true. Before I actually joined Smith Barney there was a draft at the time and a few of my Harvard business school classmates and I received direct commissions in the US Army Finance Corps where we put into effect at various army posts around the world a computerized pay and accounting system. But then I did go to Wall Street. I was an investment banker for two to three years, did finally start investing myself and made enough money so that I was convinced then that I would not continue to be poor and the thought of possibly, maybe, getting a PhD in economics since my college advisors had strongly urged me to do, was maybe something I should do. And I went to New York University night school to try to do some courses. But I found that it was simply impossible because as an investment banker we would be doing some due diligence for a company in Iowa or Chicago or the west coast and I was missing three quarters of my classes. Realized that that didn’t work and I then took a leave of absence, and I was living in Princeton, New Jersey at the time and went to graduate school at Princeton.

I fully expected to go back to Wall Street but two things happened that I had not expected. One was that the people at Princeton said, “Gee, we’d like to hire you to teach.” And the second thing was that there was a scandal at Prudential Financial where the CEO had been lending Prudential’s money to companies with which he was affiliated, and when this broke he was fired and the New Jersey legislature decided that from now on Prudential would have to have six public directors chosen by the Chief Justice of the New Jersey Supreme Court. The Chief Justice wanted to have an economist there, interviewed me, and even though I was just a fledgling economist at the time, he liked what I had to say and I became a director of Prudential Financial. And that made me decide well let me see if I like teaching. I’ve now got a foot in a business. Maybe I can do both of these things at the same time. And the board membership of Prudential led to another, a number of board memberships, and I enjoyed teaching. I was able to research the stock market, which had interested me since I was a little boy. And I then developed a life that in my view had the best of both worlds.

So I was still in the business and financial community and at the same time I was able to work on the projects that interested me in financial markets. That’s really the quick story of how I came to do the things that I’ve done.

Rick Ferri: It’s interesting when I look at your bibliography of what you’ve written. That early on in the ’60s you had written a few papers on the bond market and the term structure of interest rates. A couple of papers, one of them was, the first one was published in the Quarterly Journal of Economics. Then you went on to write a book, your very first book, on options and option strategies. So it wasn’t just the stock market and you were really expanding out into all of the financial markets at this time.

Burton Malkiel: Exactly, and was definitely interested in financial markets. The early work that I had done was all technical because you do not get tenure at a first class university by writing things that were popular. I wrote A Random Walk Down Wall Street in the early ’70s and wrote it right after I was given tenure at Princeton. So I was always interested in doing things that would be more popular than the professional journal stuff that I did at the beginning but I only did that after I had tenure at Princeton University.

Rick Ferri: So let’s go ahead and move on to A Random Walk Down Wall Street, and I have in my hand your original first edition because right now you’re up to the 12th edition. The original book itself in the 12th edition is still there, it’s still at the beginning of the book for the most part, and you’ve just been adding to the book as we have been moving along. So I’ve read both the original edition; I’ve read other editions over time; and now the 12th edition, which I also have.

But I want to quote something here in your first edition. You were an inspiration to many people, but particularly to Jack Bogle, with the idea that what was needed is an index fund that just gives you the market return. And here’s what you wrote, again this was written in 1973, that’s when the book was published, 1973.  So you were actually thinking about this and writing about it, or you know, putting your words on paper even before then. But here’s what you wrote.  This is on page 226:

“What we need is a no load minimum management fee mutual fund that simply buys the hundreds of stocks making up the broad stock market averages and does no trading from security to security in an attempt to catch the winners. Whenever below average performance on the part of any mutual fund is noticed fund spokesman are quick to point out you can’t buy the averages. It’s time the public could.”

And that was really an inspiration, I believe, to Jack Bogle.  How did you meet Jack Bogle and tell me what this first discussion was about.

Burton Malkiel: Let me first of all say two things. I appreciate your quoting that, and I am certainly very pleased to have been one of the earliest people to recommend indexing. But I appreciate being given the credit, but I do think it’s one thing for an academic to say crazy things and believe me, the first reviews of my book by professionals said that it was the biggest piece of garbage in the world. So it’s one thing for an academic to do this. Jack Bogle deserves all the credit in the world because he bet his whole company on it, and yeah I was early in recommending it, but he was the doer, and believe me, this was a very unpopular idea. As you may know, the story that Jack had hoped to raise 150 million dollars at least, and hoped for 250 million dollars in the initial public offering of the first index fund, they in fact raised 11 million dollars. It was called Bogle’s Folly.

You talk about early conversations with Jack. Sometimes I used to kid him that he and I were the only holders of the first index fund. But just in terms of the chronology, I was in Washington in 1975 and 76, on the President’s Council of Economic Advisors. Left Washington in January of ’77, and then Jack had asked me to go on the Vanguard Board, and I was a Vanguard board member for 28 years, and obviously, in terms of initial conversations, Jack and I were certainly kindred spirits, because both of us firmly believed and were both convinced that this was the absolutely best way for individuals to invest.

Rick Ferri: And you were both about the same age too.

Burton Malkiel: That is correct. Jack was a bit older. But Jack and I were roughly the same age, and Jack and I both had the connection to Princeton University, where he was an extremely loyal and an extremely generous alumnus.

Rick Ferri: The index concept, great idea, but it took so long before it caught on. In the early years, as you said, they only raised 11 million dollars in the initial offering. Now a lot of that had to do, if I recall the story correctly, it was actually sold through brokerage companies and it was sold with a commission and the commission was a little bit lower than the commission to sell active managed funds. So it didn’t get any attention from the brokerage industry in many ways.

Burton Malkiel: That is certainly correct, but it was also an idea that the brokerage community really didn’t believe. I mean there was still a view that the reason the broker was important for the customer is the broker would be able to find the mutual fund or the individual stocks that were going to outperform. And so the view that an index fund was the way to go was pooh-poohed with the idea that “who wants to be mediocre?” and that was what the index fund was. Well you know this is a mediocre investment, this is average. The fact of the matter is that index investing proved to be quite above average when you think of all the other investment products that were out there.

Rick Ferri: Well I looked at the data. In the first few years that the S&P 500, the First Index Trust as it was called, was out, and it was the first year was attempted to be sold through the brokerage firms, but then it went no load in 1977 about a year later, and so Vanguard was out on its own selling it. But there was a period of time when there was you know volatility in the market that stocks weren’t doing very well during the late 1970s, in fact Business Week ran an article called The Death of Equities. I mean so everything was against this fund. I mean it was incredible that it actually survived. However in around the beginning of the 1980s, say 1982-83, when the market started coming back, the fund finally started to pick up assets and I believe it hit a billion dollars in assets in the late 1980s. It took I think 12 years before the S&P 500 fund hit a billion dollars, but by that time I  think Vanguard was already looking at doing other index funds as well.  And this was sort of the genius of Jack Bogle. He wanted to index everything.

Burton Malkiel: Absolutely and Jack was the one who said we really ought to be suspicious of bond managers who tell you that they can outperform. Maybe we ought to have a bond index fund as well. And do we need just the S&P 500 and what used to be the Barclays Aggregate Bond Index. Maybe what we ought to have is a real estate index of REITs, and maybe we ought to have international indices. We ought to have an index that tracks EAFE Europe, Australia, and Far East. So you’re absolutely right, and this was I think the genius of Jack Bogle that there’s no reason why indexing ought to be confined to simply the US stock market. Indexing should work, and does work in all asset classes.

Rick Ferri: When I interviewed Jack, in looking at the chronology of when different index funds were launched at Vanguard, it was actually 1996 by the time the last sort of major market index fund was launched which was also ironically the year that he had heart issues and ended up having his heart transplant and ended up then resigning as the chairman. But at that point, 1996, a person could go to Vanguard and you had a whole suite of index funds, you had the US market total market index fund, you had an international index fund, emerging markets index funds, you had a REIT index fund, you had a bond index fund. It was all there. You could do an all index portfolio now at Vanguard by 1996. I think that was just an incredible accomplishment to get to that point.

Burton Malkiel: Absolutely, and remember also because of Jack, we introduced a tax-exempt money market fund, introduced bond funds with different maturities so that you had a short term, an intermediate term, and a long term. From the standpoint of Vanguard there was a whole host of products that was really all that an individual investor needed.

Rick Ferri: I want to pivot here for a second and start talking about exchange traded funds, because Jack did not like the idea. 

Burton Malkiel: That was one of the few instances where Jack and I disagreed. There’s very little that we disagreed on because as I said earlier, we were really kindred spirits. But you’re absolutely right from Jack’s point of view, exchange traded funds were the instrument of the devil.

Rick Ferri: Like giving gasoline and matches to an arsonist or something like that.

Burton Malkiel: Yeah well, as I remember, I can’t tell you how many times Jack and I would have this argument, where Jack would say, “Who in their right minds would want to buy the market at 10:30 in the morning and sell it at one o’clock in the afternoon. Anybody who thinks that they can do that and make money is absolutely crazy. People are just going to cut their throats on these things. They’re an instrument of speculation and we will never do exchange traded funds.” Because I as a board member had actually urged Vanguard to do them, and my argument to Jack was, Jack you don’t think that buying and trading exchange traded funds is something that is likely to be productive for people and I agree with you entirely, but you and I both know there are some people who will still want to do this, and when people do this in the context of a mutual fund they can create transactions costs, accounting costs and possibly even potential tax costs for those who stay in the mutual fund. It’s much better for those people who want to try to do this to do it through an exchange traded fund where there are even some tax advantages of the exchange traded funds, and for the buy and hold investor an exchange traded fund is terrific and you can do it at an even lower cost. So that was the argument that we had and Jack was never, to the day he died, never convinced that exchange traded funds were worth it. And had Jack stayed as CEO of Vanguard through his long and productive career, Vanguard probably never would have had exchange traded funds.

Rick Ferri: I have to tell you during the late ’80s and ’90s I was working as a broker, first at Kidder Peabody and then at Smith Barney, your old firm, and I had very little access to indexes. I had my “aha” moment about indexing around 1996 when I read Jack’s book, Bogle on Mutual Funds, and I’d also heard him speak at a CFA Society annual event. It was actually the first speaking event that he had after he had his heart transplant. But I mean I wanted access to Vanguard mutual funds but I could not get access when I was working at Smith Barney. Having ETFs would have given me access, given my clients access to these ETFs, to Vanguard funds, But they weren’t available.

Burton Malkiel: Absolutely, because Vanguard wouldn’t pay for a distribution, which I think was absolutely right. The only way that someone in the brokerage community who believed in this could give the client access to these wonderful index funds was through the ETF.

Rick Ferri: With Vanguard’s credit, especially with the patent that Gus Sauter, who was the former chief investment officer, created, Vanguard didn’t just create ETFs. I mean they actually created a patent where when they did launch the ETFs — and they were called VIPERS at the time, they’re not called that anymore, they’re just Vanguard ETFs — but I think it was 2001 or 2002 when they launched ETFs, they did them as a share class of their open-end funds, which was unique. It was patented. No one has done that since and what that did was make the mutual fund itself more tax efficient because the ETF was now part of that.

Burton Malkiel: Absolutely. And to the extent that there were flows out of the ETF what you could do is lay off the low basis stock which had the effect exactly what you said of making the mutual fund more tax efficient. Now there is a still a considerable amount of unrealized capital appreciation in the mutual funds and to the extent that one can lower that, if God forbid everybody started to liquidate their mutual funds, the poor mutual fund holder might get a 1099 at the end of the year saying we realized the following capital gains on your behalf and you owe some tax to the US government. To the extent that you have the ETF as a share class you are making the mutual fund more potentially tax efficient. Now that this unrealized depreciation problem is so far been only a theoretical problem because the funds and the ETFs have continued to attract money from investors and you have not had the liquidations that would create potential tax events, but it is a theoretical possibility and to the extent that you can get rid of the low basis stocks through the ETF you are making the mutual fund a more efficient vehicle.

Rick Ferri: Well the interesting occurrence at Vanguard now seems to be, and I know you’re not, you’re no longer on the board of directors, but there seems to be a big or bigger push to get people to invest in ETFs as opposed to directly in mutual funds. If people write about this on the Bogleheads forum quite frequently I feel that it is occurring.

I don’t consider it a bad thing because of the benefit, the tax benefit that occurs for everybody. If it becomes a parity, if you will, between the amount of money in the open-end mutual fund side and the amount of money in the ETF side, if there’s redemptions on the open-end mutual fund side you would sell the stock that is at a high cost basis basically that’s at a loss so that the fund could take a capital loss inside the fund, and if there are redemptions on the ETF side then you push out of the fund the low-cost basis stocks.

Burton Malkiel: Exactly yes.

Rick Ferri: It’s this double-edged way of cutting taxes and I just think it’s a fantastic idea that came up with this years ago and I really don’t know why other open-end mutual fund companies have not licensed this idea from Vanguard and done it themselves. But it doesn’t seem like anybody wants to pay Vanguard for the process.

Burton Malkiel: Yeah I think you’re probably right. But I agree with everything you said. That’s been a wonderful way of doing it and it’s another reason why Vanguard’s going into the ETF business finally has been a major plus for the firm.

Rick Ferri: Well let’s go ahead and get into your book, A Random Walk Down Wall Street. And in the latest edition there’s a lot of new stuff that you put in and this has been added over the years of various editions, so the book is getting thicker.

Burton Malkiel: Well there’s more and more going into the book. Remember the book was originally written as an investment guide and when you realize from 1973 on the whole investing world has changed. There were no index funds in ’73. What I had recommended in 73 was buying some closed-end funds at a discount, and the discounts were something like 40 percent of the time.Those discounts are largely gone now, but there were no index funds, there were no money market funds, there were no tax-exempt money market funds, and in terms of the length of the book it’s actually been for the last several editions the length has not increased because if there was new material added I’ve tried to compress other parts of the book so it really isn’t thicker than it was 10- 20 years ago.

Rick Ferri: There have been a lot of new things that I could tell went in there and one of the things you’ve talked more about in more recent editions is the value premium and high dividend yielding stocks. And could you tell us your views on, call it factor investing.

Burton Malkiel: Well let me make two points about that. First of all, one of the reasons that I’ve become far more interested in dividend paying stocks is that I really think we’ve got a very tough situation facing individual investors and particularly facing retired investors for whom the original advice was very simple you need income and you have a big chunk of bonds in your portfolio, both because of their stability and because bonds had been producing interest rates of 5 – 6 percent so the retired people could without having to go to their brokers to buy and sell things, could have that nice income coming in regularly. That doesn’t occur anymore. We’re basically in a world where more than half of the sovereign debt in the world sells at negative interest rates. Interest rates for the 10-year treasury in the United States is just over half of one percent. We live in an era that’s been called an era of financial repression, so what do you do as a retired individual? What can you do to get some income? And I do think that one of the, on a relative basis, more attractive parts of the US stock market are blue chip companies that pay well protected dividends.

That strikes me as being a reasonable substitute for what otherwise would have been a bond portfolio that otherwise might have where I might have recommended a total bond market index fund. The old kind of bond portfolio being something that you needed both for stability and for income doesn’t work the way that it did in periods past.

Now let me now get to your point about factor investing. I have been somewhat suspicious about being a one factor investor. While there’s been a long term history of the value being better than growth, we know that we go through many years, including many of the recent years, where value investing has been absolutely terrible, when people like Rob Arnott say indexing is okay but you want to do fundamental indexing, which basically is a way of tilting the portfolio toward value stocks and small stocks, that I think of that as a very good way of charging 50 basis points or more for something that is not and has not over the long pull been better than regular index funds.

Now having said that, to the extent that one wants to be a factor investor, I think a multi-factor model may give you index type performance with possibly a bit less volatility than a regular index fund. And so to the extent that one wants to consider factor investing, I don’t think you do it by buying a value fund. I don’t think you do it by just buying a small cap fund. I don’t think you’d buy it, do it by buying a low volatility fund, because we know that on the individual factors there will be long periods of underperformance. But what we know about the factors is that they tend to be uncorrelated. When one factor does poorly, another factor may do well, and what you’re looking for in investing is a portfolio where everything doesn’t happen at once, everything doesn’t go down at once. And so I have a little bit of sympathy for a multi-factor approach if it’s low cost and I think something like a Goldman Sachs ETF which is a multi-factor ETF that has had a reasonable return, I don’t think you’re going to do much better, if at all, than a regular index fund. And for most people, I’d say keep it simple. But it is possible that a multi-factor approach could give you index type returns with a bit less volatility and therefore give you a slightly higher Sharpe Ratio, which is basically the return divided by the volatility. So that if the volatility is a bit lower you get a little bit higher Sharpe Ratio.

Rick Ferri: To backtrack a little bit, to clear it up the high dividend yield approach to investing that you do advocate, especially for retirees, isn’t because you expect higher returns through the factor side of higher dividend yielding stocks. That’s really two different arguments. I mean the one is just to get the higher dividend income, that’s why you would do high dividend yielding stocks. And by the way, Vanguard has a couple of really good high dividend yields.

Burton Malkiel: Absolutely right. Yeah those are exactly the kinds of things in the category that I would recommend, and it is largely a transactions cost argument.  I mean I believe in the old Modigliani – Miller theorem that dividends really don’t matter. You could always create artificial dividends by selling off a few shares. But both from the standpoint of the transactions cost and the bother for people of having to think about periodically looking at their portfolio and selling off a few shares periodically to get income, it’s an ease of actually accomplishing what you want and a minimizing transactions cost strategy.

Rick Ferri: Very good. Well thank you for clearing that up. By the way if people were interested in doing multi-factor investing which would include value and small cap, momentum and quality, all the factors zoo, Vanguard also has multi-factor ETFs which are very low cost.

Burton Malkiel: Yeah Vanguard has recently introduced one. That’s absolutely right.

Rick Ferri: One new area that you have written about more recently and one of the companies that you’re on the board for, which is Wealthfront, has developed and launched is a risk parity strategy. Could you comment on risk parity, and you believe in it, but how strongly do you believe in it?

Burton Malkiel: Well one of the interesting things about markets is that very safe assets may very well yield more than they should, and let me make an analogy to the racetrack. And I’ve actually done articles on racetrack betting, and there’s an empirical regularity that we know about racetrack betting that I will describe to you. If you bet on every horse in the race you will have a winning ticket and you will lose about 20 percent of your money.  Why do you lose twenty percent of your money, because that’s the track take. When the track figures out the pari mutuel pool, it deducts twenty percent for their operating expenses, for the taxes that they have to pay to the government, and they don’t give that back to you, so you lose about 20 percent. Now let’s say instead you bet on every favorite. Well it turns out you lose about five or six percent of your money. Let’s assume instead you bet on the longest shot in the race. You lose about 40 percent of your money, 50 percent of your money. In other words there’s a bias in the odds where long shots go off at far less favorable odds than favorites do. So it may be the same thing in the stock market and in the bond market, where safe assets actually yield more than they should. If this was simply on an expected value basis, the same kind of rate of return expectation for all classes of assets. Well if that’s true, and there’s maybe some long-run evidence that it is true, then maybe the best thing to do is to buy some safe assets and leverage them so that they have the same volatility as the risky asset, but that they will then give you a higher rate of return.

Rick Ferri: Oh that’s an interesting observation.

Burton Malkiel: And I think that’s the argument for it, you know, as I say in the book there is some evidence that at least in the bond market this has been a winning strategy. If a few years ago you bought two and a half percent 10-year treasuries and leveraged them by borrowing at one percent or less you actually then got a much higher rate of return, and the rate of return would have been better than buying the 30-year treasury bond. Now so far that’s worked well. It made money for people like Ray Dalio and you can’t deny that it’s worked well at Wealthfront.  Our risk parity fund has actually done better than Dalio’s because our expense ratios are much lower than Dalio’s expense ratios. So it has worked. Now as I point out in the book, it might continue to work as long as the Federal Reserve keeps pumping money into the economy at the same rate that they’ve been doing it in the past, but God forbid we come to the other side of the COVID-19 crisis, the world economy goes back to some semblance of normality, and we have a little bit of inflation with all the money floating around the world, this is a strategy that might not work.

Rick Ferri:Dr. Malkiel, do you believe that the Powell Put, as it’s called, the Fed buying up corporate bonds, buying up treasury bonds, is distorting this relationship between quality and return?

Burton Malkiel: Yeah I do think that as we say in the drug industry there are some uncomfortable side effects. I am very worried about the explosion of corporate debt. I’m very worried about things. I worry about today, that a Hertz can raise equity money in bankruptcy; that when you look at institutions like Robinhood and find that Hertz was the leading stock that people had in their trading account; when it went from one to five. I think those are very undesirable side effects, and on the one hand there’s no question that COVID-19 produced an enormous crisis, we had to do something extraordinary. So I don’t fault the Fed for what it’s done, but I, count me as somewhat worried that there are side effects, and one should not ignore them.

Rick Ferri: I’m going to do a quick lightning round on Boglehead, other Boglehead questions just to wrap it up. If you don’t mind it’ll just take a few minutes.  A safe withdrawal rate has been touted at four percent; are we still at four percent?

Burton Malkiel: I don’t think so. I think again this is one of the unfortunate side effects of what has gone on with monetary policy around the world. The base rate, if you think of the sovereign rate from sovereigns like the United States and Germany, the EU, that have the least risk are essentially zero. So that the whole base of returns starts at zero, and even if the risk premium on equities continued to be five percent, which it’s been historically according to the Ibbotson data, then equities would give you five percent, or maybe five and a half percent. So you will not preserve the real value of an endowment with a four percent withdrawal rate.The appropriate rate is clearly lower and I think that institutions that retain the four, five, six percent withdrawal rates are not living in what is in my view the appropriate world.  

Rick Ferri: For my clients, they tend to use three percent. Would you agree that three percent is better?

Burton Malkiel: I think yours is much better than four.

Rick Ferri: Okay, well that leads us into another question by the Bogleheads and that is, in your book you talk about the allocation between stocks and bonds for different age groups, and you say for people who are in their 60s they should have 60 to 80 percent stocks; 70s, 40 to 60 stocks;  80s, 30 to 50 stocks. Has that changed in this new world that we’re in?

Burton Malkiel: If you look back at the additions, I have increased the stock allocation and reduced the bond allocation and frankly, if I were writing the 13th edition right now under today’s circumstances, I would probably increase the stock allocation and reduce the bond allocation a little further.

Rick Ferri: ESG–environmental social and governance– seems to be more popular here in the United States.  What is your feeling on ESG, and if you could, could you address the expected returns of ESG versus the expected returns of say, just the market?

Burton Malkiel: Well let me take the second question first. Well ESG investing has recently like in the first quarter of 2020 ESG funds have done a little better than regular index funds. The reason being that they avoid all oil companies and as you know the oil companies have not been the place to be investing in the first quarter.  However over the longer run there is no credible evidence that ESG investing will give you a higher rate of return. There have been some periods where it has some periods where it’s given you a lower rate of return, but there’s no credible evidence that you’ll be helping the world will give you a higher rate of return. In fact, quite the opposite, if for example oil companies are permanently lower because many institutions avoid them, then they will probably give you a higher rate of return over the long pull. If a particular type of company is hated and therefore sells at a lower valuation than it deserves it’s going to give you a higher rate of return in the future, not a lower rate of return.

So number one, don’t think you can do this and you can both feel good and you’re sure of getting a higher rate of return. Secondly, I’m very suspicious that you really ought to feel good about buying an ESG fund. There are various institutions that give companies ESG ratings. They’re wildly different. Some people will give you a high ESG rating, some will give you a low ESG rating. You ought to really look at what you’re owning. It’s not at all clear that if you look at these things that you ought to feel good. For example, one of the companies that gets a very low ESG rating is Kinder Morgan, a natural gas pipeline company. Now it gets a low rating because it’s carbon. On the other hand, to the extent that we use natural gas rather than coal this will be great for the environment. We’re never going to get rid of carbon completely. As an interim step, you’re much better burning natural gas then burning oil. It’s much better transmitting this through pipelines rather than through trucks or through rails where there can be accidents, and where the trucks are generally burning fuel to transmit oil, or natural gas. So is Kinder Morgan really a very bad company, or is it one of the better companies? I think you can do that with a lot of those companies that get terrible ESG scores.

Now what about the companies that get great ESG scores? If you look at what you’re holding in an ESG fund, one of the big holdings is Facebook. Well should you feel very good about holding Facebook or not? I don’t know that I’m going to feel any better for my portfolio because I hold Facebook and Twitter than if I don’t.  Now it’s true there is very little carbon output from Facebook but again I’m very suspicious that you ought to feel better about holding these portfolios and I think if this continues to grow in popularity it’s much more likely that they will give you lower rates of return in the future rather than higher rates of return and so neither should you feel good nor should you expect to get an attractive rate of return by buying an ESG fund.

Rick Ferri: Direct indexing is growing in popularity, which is very simply instead of buying an index fund people are buying or companies are buying individual stocks for you say five– all the stocks in the S&P 500 and selling each individual stock that may be at a loss to generate larger capital losses than you could generate if you just had index funds and the market went down and you did tax loss harvesting. Now I find that this works well with people who may have sold an asset and have a large capital gain but it leaves you with 500 individual stocks and probably a lot of tax problems later on down the road. So even though I’m expressing my concerns about direct indexing, could you tell me how do you feel about direct indexing?

Burton Malkiel: No, I’m actually more of a fan of direct indexing and we do this at Wealthfront. The surest way of getting an alpha is not by picking stocks but by getting an after-tax alpha. In my own Wealthfront account it’s been used to offset some capital gains from some of the real estate funds and real estate index funds that I own, and I think it’s actually a very good thing.

With respect to the longer run, are you in fact, then, just getting rid of all of your losses and your portfolio will then have larger and larger unrealized capital gains? I would say this, unless we change the tax law where at depth there is no writing up of your assets where you have to realize the capital gains but in fact what you do is just write the value, the basis up, then you avoid the long run problem of your portfolios will tend to have more unrealized capital gains. Now if they change the tax law I’d agree with you that in the longer run you’re going to pay some price but do remember that avoiding capital gains for several years has an advantage even if you later have to pay the tax because a dollar today is worth more than a dollar 10 or 20 years from now. 

Rick Ferri: I would agree with you and with no disrespect, at your age direct indexing would make a lot of sense if you had capital gains. However I’m not sure if direct indexing makes sense for a 35 year old who sold their app company for 10 million to do it because they sort of get saddled and stuck in these 500 stocks for 50 – 60 years and they have to pay fees on the portfolio to maintain it.

Burton Malkiel: We can’t agree on absolutely everything okay.

Rick Ferri: Very good, okay. One last question. This has to do with your view on China.  You co-authored a book on China which came out in 2008. China has not performed well since that time because of course there was this huge 500% run-up in the couple of years prior to the book being published. But how do you still feel about China?

Burton Malkiel: I think the problem and what’s actually been disappointing about President Xi is China’s growth has almost entirely been on the private sector not the sector of government owned enterprises. The overall indices have done very poorly because the government-owned enterprises have been terrible, but the private enterprises the Ten Cents, the Baidus, the Alibabas, those have done particularly well. You know you have to look at what’s in an index. The problem is that the index like the FXI has not done well and it’s not done well because of the state-owned enterprises. The private companies though have done well and I am still optimistic about them and to just give you an idea of how you could get just the private stuff there’s an ETF called EMQQ which has the Alibabas and the Ten Cents and in fact all of the internet companies in China that have done particularly well. So I think the answer is I am still optimistic about China but not the whole economy because I think that President Xi has been unfortunately emphasizing the state-owned enterprises and I think that’s a big mistake, and it’s one of the reasons why China’s overall growth will not be anything like it’s been in the past.

Rick Ferri: Dr. Malkiel it’s been a real pleasure. We could go on for another two hours easily. Thank you so much for being on the Bogleheads on Investing podcast.

Burton Malkiel: It’s been my pleasure, Rick.

Rick Ferri: This concludes Bogleheads on Investing episode number 23. I’m your host, Rick Ferri. Join us each month to hear a new special guest. In the meantime visit bogleheads.org and the Bogleheads wiki. Participate in the forum and help others find the forum. Thanks for listening.

About the author 

Rick Ferri

Investment adviser, analyst, author and industry consultant



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