Burton Malkiel, the Princeton economics professor emeritus and author of the index investing classic “A Random Walk Down Wall Street,” had a lot to say about the perils of relying on U.S. Treasurys for income when IndexUniverse.com Managing Editor Olly Ludwig recently caught up with him.
Malkiel also talked about what Wealthfront, a Silicon Valley-based financial advisory firm where he now serves as chief investment officer, is doing about it. Wealthfront, which now manages $170 million in investments, doesn’t charge investors anything for the first $10,000 under management, and above that an annual fee of 0.25 percent, or $25 per $10,000, kicks in. The advisory firm was the subject of the March cover story of IndexUniverse's sister publication ETF Report.
Earlier this month, the firm, which serves up an algorithmic—and what Malkiel calls emotion-free—approach to index investing, added five new sources of income to its asset allocation options: municipal bonds, corporate bonds, emerging market bonds, dividend growth stocks and Treasury inflation-protected securities. Malkiel went out of his way to single out the highly prospective nature of emerging market credits, and also stressed his belief that China’s new leadership is laying the groundwork for slower and more sustainable growth.
IU.com: Can you tease out some more nuance as to why Wealthfront rolled out more income-focused asset classes? Is it as simple as the 31-year bull market in Treasurys is quite long in the tooth and investors had best be prepared for some kind of reversion to the mean?
Malkiel: I want to say two things:One, it’s not that I’m predicting the end of the Treasury bull market, but even if rates stay where they are, Treasurys are not going to provide a real rate of return for investors. Second, that over the long haul, when we do get to relatively full employment and Treasury yields normalize, you will find that you’ll get capital losses. People ought to remember history:The last time Treasury 10-year yields were 2 percent was right after World War II. It’s not that you immediately had a bear market if you bought a Treasury bond in 1946, but because the inflation rate was higher, you had a negative rate of return, and then when Treasury yields started rising in the ’50s and ’60s and ’70s, you then had severely negative rates of return, and in fact, you suffered severe capital losses.
IU.com: Understood. So you have this near-term need that the addition of these asset classes addresses. And presumably, in the event of some kind of normalization of rates and sort of an uptick in the inflationary pressure, then these same additional asset classes will also serve investors well in that contingency. Correct?
Malkiel: That’s right.
IU.com:Now, in the event of a normalization of rates—which we seem to agree will come at some point—walk me through how these various additions are going to make a crucial difference.
Malkiel: Well, let’s take the addition of dividend-growth stocks. What we do know is, in the short run, equities don’t seem to be an inflation hedge, because if we had a spike in interest rates, it would hurt the stock market. But over the long pull, equities have been an inflation hedge. A company like AT'T has been able to grow its dividend at 5 percent a year for a long period of time, and that was a rate somewhat larger than the rate of inflation over the period.
IU.com: And can you speak to some of the other additions—TIPS, munis and emerging market bonds?
Malkiel: Well, munis are still relatively cheap compared with Treasurys, and they do have a rate of return larger than the inflation rate, and probably larger than even a 3 percent inflation rate.
The other asset class which I think is important is emerging market bonds. That's again an asset class that, when you think about history, was risky, and bonds defaulted. Actually, investors ought to start to believe and think that that might not be the case in the future, because if you’re worried about defaults, I’m more worried about Italy than I am about some of the emerging markets. Emerging markets now tend to have low debt-to-GDP ratios; they tend to have a much better fiscal balance—by which I mean the government deficits are small or there are even government surpluses.
IU.com: You’re painting with a broad brushstroke there. You’re not parsing emerging markets and isolating, say, Brazil or China, are you?
Malkiel: No. You know me; I’m an indexer. And that’s of course what we are doing with these portfolios; we’re talking about a very broad brush where we’re using a broad emerging market fund. And we’re always looking for the emerging market fund that is the most cost-effective—we’re going to see this year a Vanguard emerging market fund which I expect will have a lower expense ratio than the ones on the market today.
IU.com: In the past few years, following the great downturn of 2008, there’s been a lot of talk of this risk-on/risk-off type of market price movement, and embedded into that whole discussion has been this almost accusatory aspect regarding ETFs, that these index vehicles that are highly liquid are exacerbating the problem and may actually be making the correlations between different asset classes rise. I’m wondering if you might help me parse this argument that ETFs are somehow responsible for exacerbating this general flavor in the markets.
Malkiel: Well, if we’re talking about an ETF that’s going to give me 3x the increase in the S'P and is an ETF designed simply for speculation, I would probably join the critics and say I don’t think these are instruments that investors ought to use. But the broad-based index ETFs, where you can buy the total stock market for 5 or 6 basis points, are absolutely marvelous for investors. For the first time, this gives investors a chance to do what I have recommended for 40 years of buying broad-based index funds and now having them available at essentially zero expense.
IU.com: Right. Now, with regard to the overall ETF market, there is clear evidence that the ETF is gaining in popularity. At the same time, there has been an acceleration in the shutdown of funds, perhaps a deceleration in rollouts of new funds. And I’m wondering if you might offer just a general observation about how you see this whole new industry taking shape.
Malkiel: There are two kinds of ETFs that I’m not a fan of. I’ve already mentioned those that are simply set up for speculation, and the other ones that have sometimes had trouble are ones that are far too narrow. That’s where I think you have seen some ETFs fail to attract sufficient assets, and the growth that I see in the future will be the ones that give you broad exposures to asset classes.
IU.com: So you’re saying there is something of a culling, a survival of the fittest that is manifesting, and the fittest appear to be the very ones that you favor. Is that fair?
Malkiel: Yes, that is a very fair statement.
IU.com: Now, looking more specifically at Wealthfront, the organization that you are now CIO for, you were very plain in a recent blog that taking emotion out of investing is really going to get you closer to the ideal approach as an investor. I’m wondering about the extent to which this is resonating. I’ve had conversations with advisors who’ve seemed to be saying, “Actually, the clients seem to want more high-touch treatment at this juncture at precisely the time when technology would afford the more algorithmic approach of, say, a Wealthfront.” Help me see the way these two models might coexist or maybe even be integrated in some sense.
Malkiel: Well, first of all, I would say that in terms of what we are doing for investors and tailoring portfolios that are going to meet their needs, I don’t think we give up anything to a broker or an investment advisor who charges much more. So, I don’t see this as, “Oh this is just a cheap generic service.” We’ve put a lot of thought into this. We’ve got different portfolios for people who need to have portfolios that have different risk levels.
IU.com: I didn’t mean to ask that question as challenging the very premise of your organization, because I can get my head around its allure. Rather, I was thinking the opposite:Is this some kind of a mortal threat to the existing approach of managing investable assets?
Malkiel: Is this going to be a mortal blow to the whole industry? No, and no more than index funds have been a mortal blow to actively managed funds, because there are still plenty, So, will it gain share? Absolutely, just as index funds have gained share over actively managed funds. And I think some of these things like Wealthfront will continue to take share away from high-priced and often-conflicted investment advisors. By the way, I just got this magazine, the March issue of ETF Report, the magazine for ETF advisors, and it has a wonderful, wonderful cover story about Wealthfront, “Kiss Your 1 Percent Goodbye.”
IU.com: Now, at the risk of asking a very simple and silly question, Wealthfront is solidly in the very world you sort of identified and extoled and argued for 40 years ago, right? This is a pure-indexing type of approach with an algorithmic overlay that makes it super cheap and as close to the ideal as one could possibly get, yes?
Malkiel: That’s exactly the reason I was so happy to join the firm, because I like to be associated with companies where I simply believe wholeheartedly in what they’re doing. And it’s one of the reasons I’ve been a long-term board member of Vanguard. It just makes me feel good to be part of an organization that I can wholeheartedly believe in, and this is certainly one of them.
IU.com: Understood. Let’s turn our attention to the macro picture, and Europe for a quick moment. It seems that since last summer, when the ECB essentially did what the Fed did from the first, a measure of stability has entered into that picture. I don’t mean to say that it’s going to quick turn around and go gangbusters, but there seems to be that there’s something of a bottom in.
Malkiel: Things certainly feel calmer than they did six months ago, but we’re certainly not out of the woods in Europe. This is going to be very, very difficult for them to continue with the very high levels of unemployment that they have and then particularly the high levels of youth unemployment. So yes, things do look better, and I think they look better because the ECB with its new chief has basically turned on a dime. That has certainly helped and will continue to help.
Malkiel (cont'd.): But again, this goes back to the whole reason I’m worried:We’ve seen a shift in the ECB. We’ve seen a shift in Japan over the last several months, where they’re engaging in a very easy monetary policy and being very happy with the depreciation of the yen. Things may get better, it’s possible; but we’re also likely to be unleashing a lot of inflationary pressures around the world. Again, I don’t think it’s going to be a hyperinflation—I think that’s unlikely—but the kind of moderate inflation that killed bonds from the late ’40s to 1980 is very likely again.
IU.com: Which takes us back to the addition of these asset classes at Wealthfront?
IU.com:What about China? This is a subject that is near and dear to you. I’ve noticed that so far in 2013, for what it’s worth, a lot of the smaller tigers around China are doing quite well—the Malaysias, the Philippines, the Indonesias—which suggests that the Chinese juggernaut is sort of stabilizing and firing up. That said, when you read the tea leaves too closely, you sometimes can’t tell what’s going on. So, I’m wondering if you might offer some perspective here as far as how this transition is going with new leadership emerging and the challenge to maintain growth and address problems that sort of lurk within the whole Chinese dynamism.
Malkiel: What I see are very realistic targets of the new government—we’re not talking anymore about trying to engineer double-digit growth. We’re looking more at a growth rate with a 7 handle as opposed to a 10 and 11, and I think that that’s realistic given the size of the Chinese economy now. I think you've also seen that China has been subject to property bubbles for decades, and there are undoubtedly areas that are bubbly now, and the government in its recent action of slapping on a capital gains tax is, I think, doing the right thing. It’s not that China doesn’t have problems, but they’re trying to quiet some things down.
IU.com: What about access for foreigners? I couldn’t help but notice recently Deutsche Bank—and it may be a gesture of wishful thinking—put into registration an equities ETF focused on China that will own presumably actual A-shares as opposed to some kind of a derivative exposure like the fund (PEK) from Market Vectors does currently. What are your thoughts there?
Malkiel: The new government will move far more slowly than I would like to see them move, but I think they’ll move toward much more liberalization of the economy. It will come in fits and starts and it won’t be nearly as much probably as it should be. But my friends in China are very optimistic about the new government, and in particular, that the new government will really try to tackle another problem that we haven’t talked about, which is the kind of rampant corruption we’ve seen in China.
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