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David Stevenson: why this passive investing pioneer is worried

David Stevenson: why this passive investing pioneer is worried

Burton Malkiel is worried.

The sprightly 86-year-old professor of economics at Princeton is someone worth listening to if you are an investor, if only because of the impact of his thinking on modern investing. In fact, I’m willing to wager that many of the ideas he’s championed have probably found their way into every one of our portfolios.

Along with Jack Bogle, Malkiel is one of the founding fathers of the passive funds revolution, as a director at Vanguard for many years. He’s also a huge fan of online digital wealth advisers (especially robos such as Wealthfront in the US) and a champion of adventurous exchange-traded funds (ETFs). Crucially he’s also a big bull on China and a long-time adviser to the United States Republican party – he’s even served on the White House’s Council of Economic Advisers.

I recently caught up with the author of the seminal academic investing book A Random Walk Down Wall Street on a trip to London to help promote a new index tracking fund called the EMQQ Emerging Markets Internet and Ecommerce ETF (EMQQ).

Malkiel has long been the most coherent defender of exchange-traded funds and passive investing, all underpinned by a belief that markets are generally ‘efficient’ i.e it's hard for active fund managers to have a consistent edge over the benchmark return.

Despite the recent protestations of active fund management that benchmark hugging is a dangerous momentum trade, Malkiel is still a fan of the idea that markets are efficient.

'Look, first of all you could argue in favour of indexing even if you thought markets were inefficient,' he says. 'It is really a simple matter of arithmetic.

'If you think of the United States market it has to be held by somebody. So it has to follow then that investing is a zero sum game. If I hold the portfolio that does better than average, somebody else has got to hold the portfolio that does worse than average. We can’t all be better than average. So, let’s first of all lay to rest the idea that markets have to be completely efficient.'

Another argument advanced against passive funds is that once the majority of investment funds are tracking an index, active fund management will die away, leaving only a passive, momentum driven flow of passive funds. Malkiel certainly thinks that passive funds have much further to go – he thinks market penetration will eventually get above '60% to 70%'. But does that mean the end of active stockpicking fund managers?

Absolutely not, according to Malkiel, who suggests a thought experiment. 'Let’s assume that a biotech company announces they have just had successful results in phase three and they know how to cure lung cancer and that will double the company’s earnings and presumably should double its stock price.

'But there are no active managers, so it doesn’t go up. It’s inconceivable to me in a capitalist system, that some hedge fund somewhere wouldn’t say, “Hey, everybody is indexing now and this thing didn’t go up, I have got some capital I am going to go and buy it”.

'It’s inconceivable that you will have so much indexing that there is no incentive for somebody to go and make sure that the information gets reflected... there will never be zero active fund management. But I would add that even as index funds have become more popular, you would think it was easier to outperform but in fact the amount of number of active investors outperforming has consistently fallen.'

Another worry about ETFs is that in their drive to cut down costs, fund issuers might head towards zero fees – with underlying costs hidden from the consumer. On this Malkiel admits to concerns. 'I would tell you that you had better be careful that zero really does mean zero,' he says.

'Let me just give you one example: index funds make a lot of money with stock lending. If I sell something short I have got to borrow it to give to the buyer and index funds now do big stock lending business. There are a lot of reasons why zero may not be zero.'

Another worry for Malkiel is the rise of thematic ETFs and especially environmental, social and governance [ESG] indices, currently all the rage.

'I am getting very worried about ESG thematic funds,' says Malkiel. 'Let me ask you a question, is Lockheed Martin a very bad company in the United States because it makes instruments that kill people or is it a good company because it makes a missile defence system that makes me feel more secure living in the United States? I find this, you know, troublesome. I much prefer broad [non ESG] indices.'

Malkiel’s influence on modern investing doesn’t stop with ETFs of course.

Like another investor icon, Jim Rogers, the East Coast US academic is also a long-term enthusiast for all things Asian and Chinese. He argues that investors absolutely need to increase exposure to Asia and its rising consumer class – thus his championing of the EMQQ index tracking fund recently launched in the UK by HanETF.

But Malkiel also warns that investors in China need to be alive to state influence – and the rise of loss-making state-owned enterprises. 'The reason I am such a fan of the Asian Consumer ETF [EMQQ] is that the underlying index has got the capitalist part of the economy in China,' he says.

'What I think China realises is that hundreds of millions of people were taken out of poverty not because of extreme communism but because [former Chinese leader] Deng Xiaoping allowed capitalism to creep in. So, in some sense that’s one of the reasons why I am such a supporter of something like the EMQQ exchange traded fund which I think of as a broad index.

'There are some other key trends that matter - especially as people get wealthier, we see the rise of the middle class, which then leads to the rise of consumers using new technology. These consumers may not have an Apple phone but, you know, they all have a $150 Android or even cheaper one.'

It’s hard of course to argue with this rising Asia/China narrative, but I would suggest that it’s also impossible to ignore the parallel trend, which is the huge level of Chinese debt being accumulated. Many high-profile investors such as Jim Chanos have argued that China could face a Japanese-style debt meltdown. Is Malkiel worried?

'Look, debt is bad - most crises have involved too much debt, and debt is particularly bad when it is denominated in outside currencies. Some of the Chinese debt is denominated in dollars, most of it isn’t.

'Debt is bad when it is owned by outsiders as opposed to your own citizens. Japan has been able to deal with the highest debt to gross domestic product ratio in the world because the debt is mainly held internally. The Chinese debt is mainly held internally.'

Malkiel also reminds Western investors that Chinese consumers are still saving 30 to 40% of their income. 'They are still over-saving. So, I don’t like debt and I do worry about indebtedness but for the very reasons I have mentioned, I don’t think debt is going to make China collapse.'

But the elephant in the room in any discussion like this, of course, is a fellow US Republican: the US president and leader of the free world, Donald Trump. Isn’t Malkiel concerned that Trump's trade war with China is pushing the country into a corner it can’t escape?

'Yes, it worries me. In Asia, being able to save face is important. And once you go down a road like this it’s not going to be easy for president Xi to make a lot of concessions. There is room for a lot of mischief and I think this could hurt the world economy.

'I am an optimist in the long term though. I think there is an expression from the Bible which says that “this too shall pass”. And I am an optimist in the sense that eventually people will understand what David Ricardo, the economist, taught us centuries ago which is that the reason we want to trade is that it really can make both parties better off… it’s a positive sum game.

'I am a card-carrying Republican, I have worked in a Republican administration. I also drive a BMW. Trump would say, that when I have done that I have given my money to Germany. I think he is crazy. Am I worried? Yes, and I think it’s going to get worse before it gets better but in the long run, I think people will come to their senses. It’s like with bubbles in the market, there are going to be bubbles but eventually true value is going to out.'

Any opinions expressed by Citywire or its staff do not constitute a personal recommendation to you to buy, sell, underwrite or subscribe for any particular investment and should not be relied upon when making (or refraining from making) any investment decisions. In particular, the information and opinions provided by Citywire do not take into account your personal circumstances, objectives and attitude towards risk.

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